Commodities can loom large for unwary investors

The appeal of physical commodities is in their seeming permanence and core role. Copper, iron and other metals have been used for millennia, with steadily rising use. Expected growth in China and emerging economies seemed to promise even greater demand. And, for many years the commodities cycle did behave differently than stock markets. This was the basis for some of the portfolio diversification claims. Commodities were promoted as an element of stability for long term planning by investors; an asset class that deserved a place in portfolios. How different is today’s reality.

As with most good things, extremes set in. Advocates for commodities grew firm in their belief in a commodities super-cycle that would last for decades. Investment banks and other financial vehicles entered commodity trading and production, with borrowing becoming a bigger part of mining finance. This boosted production of key metals, such as copper. Mega-mergers between mining giants, and huge new projects, became commonplace. The result has been a sector that now behaves more like the banking sector.

The mining sector created wealth not just by extracting and refining, but by trading, stockpiling and even lending metals to secure bank loans. As mining moved from its roots, its fortune became more closely intertwined with banking. Recent stock market behaviour points to the close links between the sectors.

Many investors might be uninterested in this, were it not for the disproportionate representation of mining businesses in the London stock market. This feeds in to indices and index funds, such as Exchange Traded Funds, that are based on these averages. And, given how closely many conventional actively-managed funds follow indices, the impact on most institutional and private portfolios has been significant.

This use of indices to guide risk assessment is encouraged by regulation, but in this case has not helped investors. Twelve months ago, the most broadly based index of UK shares, the FTSE All-Share Index, had 15per cent in oil and oil-related businesses, with 11per cent in mining. That weighting distorted perceptions of risk, and bore little relation to wealth creation in the British economy. Investors need a real-world understanding of risk, rather than simply relying on indices.

Added to the challenge of mining and energy, has been weakness in many “soft commodities” such as foods. Prices of coffee, orange juice and sugar in world markets have collapsed. All this builds a picture of deflation globally, rather than the inflation that central bankers seem to fear. Rising interest rates seem a long time away, despite the continued warnings of the Governor of the Bank of England.

It is the emerging economies that typically are the losers from this, with many nations having little except commodities to export. While the US Dollar itself has strengthened, making Dollar prices for goods worth more in local currency, it threatens a crisis in the developing world. It is not just miners that have borrowed at little cost in recent years, but many businesses in emerging economies have been helped by previously-cheap Dollars. That boost has ended, and re-payment of this debt could now prove difficult.

Turmoil in the commodity sector will trigger problems in many banks and emerging economies. Deflationary pressures are likely to persist, delaying a rise in US or UK interest rates. Instead, Europe and China are likely to stimulate further. It is clear that not even the mining giants or their bankers, are good forecasters of commodity or energy prices. Nor is it something that investors should attempt. Instead, investors should consider how their portfolios are positioned for this deflationary world, and reflect on whether commodities balance risk or increase it.

Colin McLean is managing director, SVM Asset Management