Commodities’ Success Brings Calls for Caution
By CONRAD DE AENLLE
A PERFECTLY unfortunate combination of circumstances has been underpinning the global commodity markets. High fiscal deficits in the West and accelerating demand in emerging economies have created the sort of inflationary backdrop in which commodities thrive, as have out-of-the-blue events like political instability in the Middle East and in North Africa, snow in the American Plains and a cyclone in Australia.
Such unsettling developments may make the world a more worrisome place, but they are paying off handsomely for investors in commodity-related mutual funds. The four types tracked by Morningstar — diversified commodity, natural resources, equity energy and equity precious metals — show the best gains among the firm’s 84 fund categories for the 12 months through March, each rising more than 30 percent.
Performance was patchy in the first quarter, however, ranging from a 13.8 percent gain for equity energy to a loss of 2.5 percent for precious-metals funds. There is an excellent case for owning commodities for the long haul, some investment advisers say, but they also express concern about the near future. Conditions seem too good to be true for these markets, they caution, so it’s better not to chase the current rally and to wait for the next one instead.
“There are a lot of things going on here,” said Robert Arnott, manager of the Pimco All Asset fund, a portfolio that holds other Pimco funds, including two specializing in commodities. “There’s geopolitical instability and fear of inflation exacerbated by quantitative easing, which people know can’t fail to produce inflation eventually. Investors are diversifying away from stocks and bonds, which are both rather expensive.” Quantitative easing is the Federal Reserve program to stimulate economic growth by buying Treasury securities and other assets.
The many reasons to buy commodities add up to a strong reason to resist the urge, in Mr. Arnott’s view. “Of course, the time to buy something is when it’s out of favor, not when it’s wildly popular,” he said. “Commodities broadly have soared so far, so fast, that it’s time to hold back.”
That popularity may be greater than even the very benign fundamental conditions warrant. Tim Guinness, manager of the Guinness Atkinson Global Energy fund, attributed nearly $40 of the recent $122-a-barrel price of Brent crude oil, the grade traded most on the open market, to “politics and sentiment and scaremongering,” and said that the fair value was around $85.
David W. Rolley, co-manager of the Loomis Sayles Global Markets fund, a world allocation portfolio that can invest in any broad asset class, including commodities, offered another reason for circumspection: The limited size of commodity markets makes them more susceptible to big swings than stocks or bonds.
“Commodity markets are relatively small,” he said. “They can’t accept trillions of dollars of investment capital. There’s an investment desire by people that doesn’t fit. It means every one of these trades is crowded. You can get 20 to 30 percent moves up or down.”
Although Mr. Rolley said he “wouldn’t use the word ‘bubble’ yet,” he warned that any development that brings the sustainability of the global economic recovery into question could make these trades uncrowded in a hurry. That would be “perceived as very bearish for commodities and commodity funds,” he said.
But if a market top is at hand for this cycle, it would belie what Mr. Rolley sees as a much longer trend toward higher commodity prices. “We have a lot of confidence that the growth rate in domestic demand in emerging markets is going to be stronger for a long time,” he said. Those markets, he added, “are pretty commodity-intensive.”
Mr. Arnott similarly envisions “a long-horizon, bigger trend,” but says he believes that it will result less from positive developments in emerging economies than from negative ones closer to home. “The entire developed world is awash in debt-financed consumption,” he said. “The urge to get out of debt by debasing currencies is going to be overwhelming in some countries, so inflation is going to be in the picture for years.”
Investors interested in owning commodities must select which ones to buy and in what form. The two broad choices for that are physical commodities, held directly or through futures contracts or exchange-traded funds, and stocks of businesses that produce them. Investment advisers argue for an eclectic approach to both decisions.
“If you’re trying to put together a basket of commodities or other investments to hedge against inflation, I would have physical gold and energy shares,” Mr. Guinness said. “I would buy gold and put it under my bed,” he added. “You can’t do that with oil.”
As he sees the situation, energy stocks are less cumbersome than the physical materials, and also cheaper. That could make them a good value, even if the price of crude oil retreats from its recent advance.
“In my view, energy equity prices bake in a $60 price” for oil prices, he said, “and oil is definitely going to average more than that in the next five or 10 years.”
FRED STURM, manager of the Ivy Global Natural Resources fund, says he thinks that stocks now make better investments than the related physical materials in many commodity markets. In fact, he would prefer that commodity prices hit the brakes, to reduce the risk of putting a drag on global growth.
Mr. Sturm especially likes companies that drill wells and perform other energy-production services, as well as producers of coal whose customer bases are in emerging economies.
“We have reallocated in favor of energy and away from most other materials,” he said. “It’s not unusual based on past business cycles to see a fast outperformance phase from the materials-resource sector and then have energy sectors outperform for a subsequent period.”
Mr. Arnott emphasizes diversification across different types of commodities.
“When investors start to cherry-pick individual commodities, they’re going to get it wrong,” he said. He suggested that long-term investors ease in with a dollar-cost-averaging strategy — investing the same dollar amount each quarter. But he wouldn’t be in a hurry to start.
“You can have cyclical bear markets within bull markets, and with valuations stretched there is a risk of that,” he warned. “Commodities could be priced lower a year from now. One- to three-year swings can be big swings.”
