- Commodities should be an essential part of a portfolio going into 2018.
- I’ll discuss the risks and rewards scenarios that will help you better assess portfolio exposure.
- Some commodities have better risk reward ratios than others.
Today, I’ll continue with my discussion on how to prepare an all-weather portfolio for 2018. No one knows what will happen this year, therefore it’s best to be prepared for anything with careful risk reward portfolio allocations.
In this article, we’ll dig deeper into commodities as they are supposed to do well in an environment of economic growth, especially if there is inflation.
According to the IMF, global economic growth is strengthening and should be at 3.8% in 2018 where emerging economies will see the highest improvement in growth.
In line with economic growth, demand for commodities should be strong and therefore we could see some strength in sector returns, especially in the form of dividends. Further, if there are no economic shocks, the outlook for commodity producers is very positive for the next 5 years as commodity exporters are expected to triple their contribution to global GDP growth. This is also partly due to the extremely low commodity prices in the past few years that hopefully bottomed out in 2016.
However, it’s extremely important to note that such rosy predictions like the ones from the International Monetary Fund and other institutions usually exclude potential economic shocks and are always pretty linear which is something that never happens. Therefore, one must approach commodity investing by carefully analyzing each sector in order to see what the risks and rewards are.
I’ll discuss what the largest commodity producers have to say which will give us a good overview.
The current commodity environment is still tight.
If we look at what Glencore has to say about copper, cobalt, lead, zinc, nickel, and coal, we can see that demand is strong while there are a lot of issues related to supply.
Copper supply is plagued by lower ore grades and underinvestment. It’s questionable whether the industry will manage to supply enough cobalt for the demand from the electric vehicle industry. Zinc usage is rising as emerging markets increase galvanization while past low prices didn’t really inspire miners to invest. Nickel could also really boom thanks to the battery revolution while thermal coal is still used around the world and is currently in a growth phase given the growth in emerging markets.
I must say, I agree with Glencore’s current vision as such is the nature of commodities, i.e. cyclical. Declining and low commodity prices lead to low investments which, when the situation turns, creates supply gaps. However, when there is an economic slowdown, which usually happens when everything looks to good to be true—like in Glencore’s presentation above—commodity prices drop extremely fast.
What we have to keep in mind, then, is the risk related to investing in commodities and properly weigh such investments in a portfolio. In my article on why you need gold in your portfolio in 2018, I discussed how low cost gold miners can easily lose 50% of their stock market value while leveraged miners with lower margins could easily go bankrupt if the situation in the gold market turns negative. Well, a similar risk reward scenario holds for commodity miners, especially since commodity prices really spiked in 2017.
Copper prices are up 30% in the last 12 months which shows the strength, but also increases the risks for the metal.
Zinc prices are also at multi-year highs which makes investing in the sector riskier than it was in the past.
Iron ore prices have had a terrible time in the last 5 years, but have been showing strength in the last two years.
This iron ore chart is significant because it shows how high commodity prices can go if supply isn’t able to meet demand. As the marginal customer sets the price for the whole sector, we could see much higher prices for all commodities, especially those with imminent supply gaps like copper and zinc.
A metal that still shows subdued prices is Nickel. The low prices are due to extremely high inventory levels around the world. However, those levels are declining as demand is increasing and there is more demand than the amount produced. We can expect a similar situation to happen with Nickel as has been the case with copper and zinc.
The positive outlook for nickel comes from expected increased demand for batteries which will also increase demand for copper and cobalt.
If the positive trends in the global economy continue and demand from various disruptive sectors significantly increases, we shouldn’t exclude seeing some commodity prices spike as was the case for nickel in 2007 when its price increased 4-fold. This is also the main reason why one should be exposed to commodities.
However, one should also look at the risks that can come in the form of global economic shocks which could quickly change the rosy picture the world commodity producers have at the moment. Therefore, I think commodities are still a good investment going into 2018. Not as good as was the case last year, especially for zinc and copper, but it could still lead to good returns.
If economic growth continues and we see inflation, commodities will continue to do well.
If economic growth slows down, especially in China, commodities will suffer.
Therefore, it’s extremely important to have proper portfolio allocation for the sector. In the long term, certain commodities like copper will do extremely well but you have to see whether you and your investments can weather an eventual drop. Rebalancing around risk reward is the key here.
Keep reading Investiv Daily as we still have to discuss equities, both developed and emerging market, and credit.