In a speech to the Institute of Economic Affairs on the 27th February 2008, BoE deputy governor Rachel Lomax said the outlook for the UK economy in 2008 and beyond had “changed dramatically”.
The Bank of England (BoE) warned inflation was set to “rise sharply” in the near term and there is nothing the Monetary Policy Committee (MPC) can do about it.
Lomax believes cost pressures have not yet fed through fully to consumer prices, with higher utility bills at the forefront.
While the BoE foresaw some form of correction in financial markets, Lomax said the extent of the recent reverberations was not fully appreciated. “There have been financial and banking crises before, but not on the present global scale, and this must surely be the largest ever peacetime liquidity crisis,” she said. “There may be more shocks to come.
The focus of current concerns is how far other assets may be impaired, as a result of the broader economic impact of this period of financial stress”.
All Investors are susceptible to unanticipated inflation, which may result from what economists call “externalities” or shocks to the financial system such as short-term wars (Gulf Oil War of 1990-1991), inclement weather (periodic droughts, floods and frosts), and currency devaluations (Asia in 1997 and Russia in 1998).
Through much to the 1990’s, developed economies appeared to have moved into what was described in the USA as a “Goldilocks” state, i.e. the economy was not too hot and not too cold. It seemed as if the authorities had somehow managed to remove both “boom and bust” from the economic cycle and maintained a low and stable level of inflation.
In these conditions, investment in financial instruments made perfect sense. Generally falling interest rates from the peak reached in the early 1990s, meant that Bonds represented a sound investment for much of the 1990s. Equally, many years of uninterrupted growth in the developed economies resulted in generally consistent Stock market returns at around a 20%pa return.
At the same time, the returns from raw materials and commodities were not in the same league as either stocks or bonds. Indeed, it is possible, if not probable, that the declining prices of raw materials in real-terms may have benefited the bond market and supported stock market valuations in the last decade.
However, it should be clear that current market conditions are extremely unstable with the fallout from the global credit crunch yet to fully work through the system. Our central view is that there is a high degree of “pent up” inflation within the global financial system, which has been masked by falling manufactured product costs coming out of China.
The case for commodity investment
An investment of this kind is designed to complement a typical portfolio’s asset mix to help reduce overall risk of that fund without giving up the return that similar risk reduction strategies (such as allocating from equities to bonds) would do. We believe adding commodity exposure to a portfolio’s strategic asset allocation can provide significant diversification benefits due to their negative correlation with equity and bond returns. However, as with any asset class, we believe that an investor should never invest too heavily in any one asset class.
Commodities provide diversification
The threat of inflation is a great concern to investors. Most traditional asset classes, such as equities and bonds are a poor hedge against inflation, i.e. they underperform during periods of high and rising inflation. This is typical late in the economic cycle. By contrast there is considerable evidence to show that Commodities perform at their best in such periods, i.e. that commodity prices are positively correlated with inflation. Hence an allocation to Commodities can provide a portfolio with downside protection during periods when equities are at their weakest.
In very simple terms, an economy such as Ireland that is an importer of raw materials and energy will tend to “import” inflation as a result of rising commodity prices. One way in which an investor can “hedge” the inflation risk, is therefore to directly invest into the underlying commodities.
There is some evidence that in periods of rising inflation, Commodities are the best performing asset class, and furthermore that when equities are performing at their worst, producing negative returns, commodity futures perform at their best.
Risk reduction without return reduction
Historical analysis of commodity futures returns shows they have generated a total return very close to that of equities. Research by the Yale International Centre For Finance* focusing on the period from December 1959 to March 2004 showed that the return on an equally weighted basket of commodity futures was similar to the return on equities and in excess that on bonds, returning just over 5% p.a. in real terms. As with equities, the bulk of the return from investing in Commodities coming from a risk premium.
However, subsequently, academics have challenged their paper, claiming that their entire 5% risk premium has been generated from an annual rebalancing between commodity futures and that therefore there was no intrinsic value in the actual investments. The added value from a regular rebalancing of a portfolio is well understood in investment theory but it would seem unlikely that all of the return could be attributed to this.
We feel, as in all investment matters, that investors should aim to balance these issues. We anticipate that given the continued Industrialisation and urbanisation being seen in China, India and other “emerging” economies, that demand for some commodities should continue to be well supported, and this would be the case irrespective of a slowdown in the US.
Equally, we feel that reasonably strong arguments can be made for supply inelasticity of some commodities. For example. the theory of “peak oil” suggests that humanity has already used half of the reserves of oil. Much of this is based on speculation and nobody really knows how much oil is really left. However, the fact remains that when a finite commodity is consumed, then one day it will run out.
We don’t know if commodity returns will continue to match those on equities over the long term. However, even if returns were half of the historical rate, we believe that an allocation to the asset class is still of benefit to a portfolio. This is because the real added value from Commodities comes from their negative correlation to other asset classes, i.e. they react completely differently to equities and bonds in certain macroeconomic circumstances.
*Yale International Centre for Finance “Facts and Fantasies about Commodity Futures” by Gorton & Rouwenhorst (2005)
Have I missed the boat?
Research by Seamans Capital Management shows that Commodity prices, measured in inflation adjusted terms, reached levels equivalent to their 1930’s lows in mid-1999.
Thus although commodity prices have risen sharply in recent months, we believe that they still remain undervalued in real terms.
Commodities have had five mega upmoves in the last 200 years and the sixth one is now underway. On a big picture basis, we believe that the current commodity rise is still young compared to previous upmoves and the upside potential is wide open. Each commodity upmove has also coincided with a war…
Also previous moves took place under the Gold Standard and not with money supply growth of 15 to 20% per annum being seen in western economies today. Finally, there was no Chinese or Asian Industrial Revolution in previous commodity upcycles.
We share the concerns being raised by the Bank of England and echo the warning offered by the Financial Services Authority (FSA) in the UK in 2007 regarding the faith investors and their advisers had in the benefits of asset diversification. In the FSA´s Financial Risk Outlook 2007 the regulator said ´Instruments that have been traditionally used to balance portfolios due to their low or negative correlation may no longer necessarily fulfill this role as effectively, because they now appear to be moving together.´
It is time to reappraise investment portfolios and to consider including selected commodity and precious metals investments. We believe that Investors should prepare themselves for a period of sustained volatility in financial assets combined with a high risk of inflation and that diversification into commodity investments should provide some protection.