Opinion

James Saft

SAFT ON WEALTH: The case against commodities grows

July 24, 2013

July 24 (Reuters) – Buying commodities in order to diversify
your portfolio might not be that bright an idea after all.

A new study from the Bank for International Settlements
disputes the idea that adding commodities to a portfolio can
lower the volatility of returns. Considering that this has been
the bedrock idea underlying the buying and selling of
commodities as an asset class over the past 15 years or so, this
is big news. ( www.bis.org/publ/work420.pdf )

Taken in combination with trends negative for commodities
markets like the migration of manufacturing back to developed
markets and 3-D printing, there may be fewer reasons for
investors to consider the asset class.

The study, by Marco Lombardi of the BIS and Francesco
Ravazzolo of Norges Bank, looked at correlations between returns
in commodities and equities markets and found that, having been
about zero for a decade, they have increased markedly from 2008
to now.

Rather than moving in different directions, commodities
markets have been moving along with equities, creating more
volatility for portfolios.

Lower volatility, or a return that does not jump around as
much, is a key concept in investing, as it allows you to take on
more risk and get a higher overall return since you have a lower
chance of being caught short by a sudden move in markets.

Unfortunately, that simply doesn’t seem to be true anymore
for commodities and ironically it seems as if the huge rush of
investors into the asset class in recent history is a big part
of the reason why.

Returns in commodities markets in the past were driven more
than they are now by market-specific issues. Think about a
refinery fire or a drought. Now, however, since more of the
market is owned by investors rather than driven by users and
suppliers there is a higher chance of prices being driven by a
pass-through from shocks to the real economy. As those shocks
also drive equity prices, correlations rise.

The authors do make the case for commodities investment, but
based on evidence they see that you can predict commodity prices
using information from equity markets, thus allowing you to
better time allocations in and out. That seems to me dangerously
close to saying that if you can predict equity prices you can
predict commodity prices. Frankly, if you can market time (hint:
you can’t) you ought not to be bothering with commodities or
academic research at all.

The great thing about diversification is that it isn’t
predicated on knowing the future, only on making sensible
decisions about risk. If that is gone, a major support for
commodities investment is gone with it.

CASE GROWS AGAINST COMMODITIES

This is also happening at a time when some other
long-running trends may be beginning to darken the long-term
outlook for commodities prices.

A variety of trends may be bringing more manufacturing back
to the U.S. from China and elsewhere, the so-called “onshoring”
process. This is partly because the discovery of new energy
resources in the U.S. is lowering costs there, and partly
because wage differentials between the two countries, while
still large, have narrowed enormously in recent years.

Production in the U.S. is simply less commodity-intensive,
both due to lower travel and energy costs, but also because U.S.
infrastructure is relatively better developed than that of China
or Thailand or India, making for fewer huge-energy intensive
development projects.

As well, as Morgan Stanley economist Manoj Pradhan has
pointed out, higher labor costs act as an incentive to minimize
commodity use, reinforcing the commodity-negative impact of
onshoring.

The development of 3-D printing, a manufacturing process in
which objects are literally sprayed into existence rather than
mass-produced, could also be hugely negative for commodities
prices. In part this is because 3-D printing isn’t all about
massive scale, the way the assembly line is, allowing you to
locate small manufacturing sites close to clients.

Well known futurist and investor Esther Dyson makes some
interesting points about the implications of this, arguing that
it will hit transport and logistic companies hard, as there will
simply be less moving of stuff around in a 3-D world. ( here
)

Dyson also notes that the rise of 3-D printing will lower
the inventories which companies are forced now to hold on hand.
As U.S. goods inventories total about $1.7 trillion, about 10
percent of annual GDP, the transition from assembly lines to
on-demand 3-D printing will at the very least be a one-off shock
to commodities prices.

I am sure there are many specialist investors out there who
make, and will continue to make, very good money investing in
commodities.

Given the high costs of active management of commodities
investments though, and the very compelling reasons to think
these are markets heading for a shock, now might be a good time
for most of us to narrow our focus.

(At the time of publication, Reuters columnist James Saft did
not own any direct investments in securities mentioned in this
article. He may be an owner indirectly as an investor in a fund.
For previous columns by James Saft, click on )

(James Saft)

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