The question whether to invest in commodities seems particularly relevant in this market environment. Accelerating economic growth amid the specter of higher inflation and interest rates may encourage investors to look toward commodities, and perhaps seek exposure through commodities-focused exchange-traded funds (ETFs).
In the past we’ve likened technology to a common denominator. The same is true of commodities. They thread our everyday lives. But investing in commodities is not a one-size-fits-all proposition. And it’s typically fraught with risk. Is there a better way to gain exposure, one that limits some of the volatility? We address that question and more with a Q&A.
For perspective, where do commodities fit in our lives?
They’re everywhere. In How Disruption Will Change Our Lives and Portfolios, I mentioned how routine innovative technology has become. That same perspective can be applied to commodities.
Our homes are framed with wood and steel, which often includes alloys such as zinc and nickel. The pipes that bring us water are likely made from copper. We use crude oil, propane, petroleum, and natural gas to cook, heat our homes, and travel. We eat wheat and corn, the latter of which is also an important biofuel. We use soybeans for cooking oils. Coffee and cocoa beans deliver our caffeine and sugar fixes. Many of our clothes are made from cotton. We often express love with precious metals, like gold, silver, and platinum, all of which have industrial uses too.
Batteries help keep us connected. Right now, there are earth metals working to bring you this article on your smartphone, tablet, or desktop.
What’s the current state of the commodities market?
Some market observers believe the stars could be aligning for commodities to begin their next supercycle. The financial crisis and its aftereffects, combined with a rather lengthy period of oversupply, depressed the commodities market for the better part of the last decade. However, the landscape appears to be changing.
Synchronized global growth across developed and emerging markets comes at a time when certain segments of the commodities market (energy and mining) are drawing down existing supplies and rebalancing. With improving economic fundamentals and what could be rather extended runways for growth among commodity-heavy emerging markets like Brazil and Russia, fundamentals could be more attractive.
That potential for investment in infrastructure may provide a tailwind, not only for energy, but metals like copper as well (see Copper, Explained). The shinier metals, including gold, silver, and platinum, may be attractive as well.
What will likely determine how commodities prices track?
That question has been popping up a lot amid the recent Federal Reserve (Fed) tightening. Of all the factors that can affect prices, whether macroeconomic or geopolitical, monetary policy is one that can have an outsized effect.
The wrinkle for this rising rate environment may be a long-awaited inflation uptick. Inflationary pressures appear to be gathering steam, though some of the fears may be overblown at this point.
We’re still in a rather extraordinary low-interest rate situation following the financial crisis. But typically, the Fed increases rates to keep an accelerating economy from overheating. Such economic growth usually includes heightened demand for commodities as part of broad capital investment (e.g., infrastructure). Also, should equities pull back as rates rise, commodities can become more attractive to investors as equity alternatives. The result is often more robust price dynamics.
In terms of prices, what should investors know about contango1 and backwardation?
Forecasting prices is a slippery slope. What’s important to know is that much can happen between locking in a commodity at one price and selling it at another.
Using the oil futures1 market as an example, investors need to consider two concepts: contango1 and backwardation.1 The futures market would be in contango1 if traders pay more to lock in a shipment at a given price several months away than they would right now.
The idea would be to buy oil at the current spot price,1 store it, and sell a futures contract at a higher expected price expected.
How can commodities be used in a portfolio and what can they provide?
Many investors may be wary of commodities. Even under the best of circumstances commodities investing often isn’t for the faint of heart given the potential for wild price swings. But if commodities are on the cusp of a new supercycle, which typically last 10-15 years,2 a buy-and-hold strategy could be a source of ballast for a portfolio.
First, investors need to choose the commodity, be it gold, silver, copper, oil, or gas. It could also be an agricultural product, such as grains or corn. And then they have to select the appropriate investment vehicle for them, whether an equity, or a future, or an ETF that utilizes equities or futures.
When constructing a portfolio, diversification is a key consideration. And commodities can at different times offer a long-term investment portfolio both diversification and growth. Given their complexity going the ETF route can provide direct and indirect exposure to a single commodity or a diversified group.
How can ETFs serve as a vehicle for gaining commodities exposure?
Investors may want to view broad exposure as an operative phrase when looking into commodities. The price swings can be substantial, and are not for everyone. However, ETFs may offer the kind of direct and indirect exposure that can make those swings lower more digestible.
With the commodities market possibly prepped for its next supercycle, which tend to be roughly double the length of most economic and business cycles,2 investors could consider blending commodities into their portfolios in a measured, processed way.
To recap: What are three key commodities takeaways right now?
- Fundamentals, including the global macroeconomic backdrop, appear to be aligning for renewed investor interest in commodities.
- Growth in developed and emerging markets alike could increase demand for commodities due to capital investment. Rising inflation and interest rates, as well as increased volatility in the equities market, may encourage investors to potentially seek investments outside of equities (i.e., commodities, bonds) and, in turn, potentially drive up prices.
- Investing in commodities is fraught with risk, typically making broad exposure an effective approach where appropriate. However, ETFs can offer broad exposure that may limit some of the concentration risk.
Futures: an agreement traded on an organized exchange to buy or sell assets, especially commodities or shares, at a fixed price but to be delivered and paid for late
Contango: the futures price of a commodity is above the expected spot price.
Backwardation: the price of a commodities’ forward or futures contract is trading below the expected spot price at contract maturity.
Spot price: current price in the marketplace at which a given asset such as a security, commodity or currency can be bought or sold for immediate delivery.
2Source: Bank of Canada (https://www.bankofcanada.ca/wp-content/uploads/2016/11/boc-review-autumn16-buyuksahin.pdf)
If you have any concerns about whether the investments discussed are appropriate for you, please speak to a financial professional. Futures are a type of derivative contract, which are subject to illiquidity and counterparty risk. Derivatives may be more volatile than the underlying investments.
Investing involves risk, including the possible loss of principal. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Narrowly focused investments and investments focusing on a single country may be subject to higher volatility. There are additional risks associated with investing in base and precious metals as well as their respective mining industries. Investments in smaller companies typically exhibit higher volatility.
Securities in SOIL’s portfolio may be significantly subject to the effects of competitive pressures in the fertilizer industry and the price of fertilizer commodities. These prices may fluctuate substantially over short periods of time so the Fund`s share price may be more volatile than other types of investments. In addition, fertilizer companies may also be significantly affected by import controls, worldwide competition, liability for environmental damage, depletion of resources, and mandated expenditures for safety and pollution control devices.
SOIL, COPX, GOEX, LIT, SIL, and URA is non-diversified.
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