Commodities

Why Global Markets Could Be Derailed by the Ukraine

Turmoil in Emerging Markets hit investor confidence in January and, after a stellar February, the crisis in the Ukraine could lead to profit taking this month. Indeed, volatility spiked to a similar level and the S&P came off its all-time-high on Friday as fears started to set in.

(more…)

Russian Investment Opportunities: The Drivers and the Hidden Gems

From the world’s best performing index in the first three months of this year, to a laggard this quarter, the Russian index has offered dramatic returns as well as downside risk. What has driven investor sentiment and what are many investors missing?

The World Leader Slips to World Laggard

Russia’s RTS Index was the world’s best performing index in the first three months of this year but has now fallen by around 11% in value so far this quarter (Source: Bloomberg). Moves in this market are often attributed to sentiment over the oil price due to the significant revenues generated by the country exporting this commodity. Therefore speculation over economic growth (read: oil demand) is highly influential. This year has been no different. Turmoil in the Middle East can be attributed as one of the main drivers of a strong rally in oil in the first quarter and concerns over economic growth has caused a reversal since that time. However, is this too simplistic a view and aren’t there other factors to which an investor in Russia should be paying attention?

Source: Bloomberg. Russian RTS Index (white) vs. MSCI World Index (orange) - all $.

Beyond Oil

It is clear to see why investors play so much emphasis on the oil price as a dictator of Russia’s financial health. Supplying some 11.4% of the world’s oil supply last year, Russia is the “biggest single source outside the opec cartel”. Although official figures calculate its contribution to Russia’s GDP at 9%, it is important to be aware that speculation over tax avoidance suggests the value may be nearer to 25%. Nevertheless, what is often overlooked is the specific oil price factored into their budget. For this year, a price above $75/barrel will produce a deficit reduction. With Brent currently standing at $115/barrel, a fall in the Russian Index in reaction to a fall in the oil price to anything above $75/barrel may be missing the point.

Boosting Ties with Iraq

With Russian oil fields maturing and production growth resting heavily on foreign investment, the country is looking externally for new sources. Iraq offers potential opportunities and TNK-BP, Russia’s 3rd largest oil producer and BP Plc’s 50-50 joint venture, isn’t holding back. The relationship between the two countries dates back many years and in 2008 Russia wrote off most of their $12.9bn debt mainly generated pre-gulf war from the Saddam Hussein government purchases of Soviet weapons. Interestingly, last October the Russian President, Dmitry Medvedev announced his country was ready to strengthen co-operation with Iraq, the same month TNK-BP gained the right to bid for 3 natural gas areas in the region.

Mediating the Exit of Qaddafi

Within the political arena, Russia has been just as active. In addition to fighting for a stronger developing market influence at the IMF, Russia has offered its services to facilitate the exit of Qaddafi from rule in Libya. This is the first time it has shown support for the NATO-led military campaign after abstaining from UN Security council vote in March which authorised the intervention and accusing NATO of violating the resolution by backing anti-Qaddafi rebels and causing civilian casualties from air raids. Due to the belief that Qaddafi has “forfeited legitimacy”, they are willing to negotiate his fate with members of his entourage. Evidence of the country’s powerful network, the value of their political clout has been highlighted.

Driving the Agriculture Market

Back to commodities but from a different angle, the Russian weather is an influencer to watch for investing in the agriculture markets. Fine weather has prompted an upward revision of Russian grain production with the Federal Hydrometerological Center reporting the warmer weather has improved the prospect for crops. This has led to speculation that Russia’s ban on grain exports may be lifted on 1 July. Wheat future prices saw double digit losses.

The Chinese Buyer

One particular potential buyer of Russia’s resources is China, state media reported last Monday. China Investment Corp (CIC), the country’s $300bn sovereign wealth fund, was set up in 2007 to invest some of the country’s massive foreign exchange reserves. With the world’s largest foreign capital resource, at $3.0tn, they are keen to find better sources of return and commodities to fuel their rapid economic growth.

G-8 Bullishness Boosting Appetite for Risk

Despite these many factors which may influence Russia’s outlook, financially, economically and politically; its index continues to exhibit a strong correlation to the oil price. This week we’ve seen oil (and Russian equities) respond positively to the declaration by the Group of Eight that the global recovery is strengthening.

Investment Insight

Nevertheless, to differentiate between short-term over-reaction and more logical fundamental moves, being aware of all the issues will equip you with the insight to navigate this volatile but potentially profitable market.

Gold may Glitter but can it Deliver?

The classic “safe-haven” investment has seen a strong uptrend in its value since the autumn of 2008. Risk aversioninflation fearsfalls in the dollar and demand from the east have all been credited as drivers of this move. But just how supportive are these factors going forward — what is the risk gold could lose its lustre?

A Hedge against Inflation

The fear of inflation is heating up as on Wednesday the Bank of England suggested that “there is a good chance” inflation will hit 5% later in the year, far above the target rate of 2%. Elsewhere, on the same day, Chinese inflation figures surprised on the upside. However, is gold an adequate hedge? It can be shown graphically that it is not. Charting the inflation rate (CPI change year on year) against the gold price, we can see that over the past decade the relationship breaks down. Indeed, if the gold price kept up with increases in general price levels, it would be valued at $2,600 an ounce instead of around the $1,500 level. How about if instead of actual inflation, we look at the market’s expectation of inflation? Even in this case, the relationship does not hold. Instead, there are other factors at play. As previously discussed, investors may be more focused on the sustainability of the economic growth rate and allow for some inflation. Inflation alone may not provide sufficient support.

The Gold Price (white) vs. CPI change year-on-year (orange). Source: Bloomberg

A Beneficiary of Risk Aversion

So — could upcoming economic, fiscal or political disappointments sufficiently boost the gold price? Here the case looks stronger. From sovereign debt crises in Europe, to the tragic tsunami in Japan and the turmoil in the Middle East, there has been enough newsflow to stoke fears and flows into gold (a “whopping” $679m of capital was invested in precious metals in one week alone at the beginning of April). Furthermore, a lack of confidence in the dollar further boosted investment for those looking for a more reliable base.

Demand from the East and Central Banks

In addition to jewellery demand, central bank purchases may provide much support for gold as we move forward. Russia needs to acquire more than 1,000 tons and China 3,000 tons to have a gold reserve ratio to outstanding currency on parity with the U.S. This is even likely to be an understatement with China stating publicly they would like to acquire at least 6,000 tons and there are unofficial rumors that this may go as high as 10,000 tons.

A bubble with no clear end

George Soros described gold as the “ultimate asset bubble” and with sentiment driving the price as much as fundamentals, it’s unclear when the trend will reverse. An increasing monetary base is looking for a home. As Marcus Grubb, MD of Investment at the World Gold Council was quoted as saying at a ‘WealthBriefing’ Breakfast on Thursday: “In the next 10 minutes the world’s gold producers will mine $3m of gold, while the US prints $15m.” However, an often-overlooked drawback in investing in gold is its lack of yield. With some stock offering attractive dividend yields and investors wanting their investments to provide attractive returns during the life of their investment, capital flows may wander.

The Investment Insight

Remain wary of relying on one driver of returns; it can often be overshadowed by another. Instead build a complete picture and continuously question your base case scenario. Gold is a more complex asset than many give it credit for and as always, it pays to be well diversified.


Libya – Oil, Water, Gold – The Real Issues

The oil price has sky rocketed over the past few months. The finger has been pointed at the troubles in Libya and claims of supply disruptions have dominated the press. However, are these claims grounded in fact or are we watching yet another sentiment driven bubble? What are the issues we should be aware of and how should we best invest in the face of such turmoil?

Expectations are often more damaging than reality

Libya’s contribution to global oil production is in stark contrast to the column inches it has been awarded in the press. As quoted by the National Journal, the country produces around 2% of the world’s oil. OPEC (Organization of the Petroleum Exporting Countries) has claimed that they have managed to “accommodate most of the shortfall” and instead attribute the rise in the oil price to fears of a shortage rather than any genuine supply issues. Oil reached a 2.5 year high last Friday. This is against a flattish demand side dynamic. Paris-based International Energy Agency and the U.S. government’s Energy Information Administration left fuel demand growth for this year unchanged and OPEC only raised their forecast by a relatively small amount (to 87.9m b/d from 87.8m b/d).

Note - this chart also highlights the Crude vs. Brent trade with the discount at record levels. Source: http://www.tradingnrg.com/crude-oil-price-forecast-recap-for-march-and-outlook-for-april-2011/

EU Sanction: A further boost for the oil bulls

On Tuesday, the EU extended sanctions against Libya to include energy companies, freezing assets in an attempt to force leader Muammar Gaddafi to relinquish power. Phrased another way, by the German Foreign Minister, this is a “de facto embargo on oil and gas”. Approximately 85% of exports are for delivery to Europe and importers will now have the task of finding potentially more distant and/or expensive alternative sources.

The pent-up downside risk

Nevertheless, many are not paying attention to the downside risk to the oil price as we move forward. Libya has Africa’s largest proven oil reserves but 75% of the country’s petrol needs are met with imports because of limited refinery capacity. Any improvement on this front, if a regime change is eventually secured, could significantly reduce imports and boost global supplies.

 Is water the next oil?

In addition to oil reserves, one asset belonging to the Libyan government which is rarely mentioned is an ability to bring water to the desert. With the largest and most expensive irrigation project in history, the $33bn GMMR (Great Man-Made River) project, Libya is able to provide 70% of the population with water for drinking and irrigation. The United Nations estimates that by 2050 more than two billion people in 48 countries will lack sufficient water, making this an enviable asset indeed.

How can the US pay for the Libya intervention?

It is interesting to note, with all the claims being made that the intervention is oil motivated that, Libya has another form of ‘liquidity’.  According to the International Monetary Fund (IMF), the country’s central bank has nearly 144 tonnes of gold in its vaults…

How to best invest: Retain context

The tide is starting to turn, Goldman Sachs has called the top for commodities in the near-term and oil fell by 4.5% on Monday and Tuesday alone (Source Bloomberg) . With this amount of volatility, short term noise can sometimes overwhelm. For a long term investor, looking for steady and stable returns, an ability to cut through the sentiment (whilst acknowledging it’s importance in driving returns in the shorter term) is valuable. Often many factors are at play and it will ‘pay dividends’ to be well-informed as they become wider known and priced in by the markets. Knowledge may be king but preparation will come up trumps.

Stagflation – A Risk Worth Noticing

The supreme art of war is to subdue the enemy without fighting – Sun Tzu, The Art of War

Much is made in the news of the risk of inflation. We can’t step far outside our doors without being faced with the challenges it brings. From shockingly high petrol prices to rising agriculture costs hitting our shopping bills, the fear is setting in. However, when we strip out these volatile elements, just how much of a problem is core inflation? Instead, with economic growth precariously fragile, when it does become a concern, won’t we be left fighting a ‘war on two fronts’? It’s time we start to notice the ‘Elephant in The Room’.

An Anaemic Recovery

The economic recovery remains weak. Still driven by the consumer, the environment for spending is tenuous. Retail sales for December were downgraded and January’s figures can only be described as “unspectacular”. We saw the first increase in the claimant count in four months (which would have been even higher had people not given up the job search entirely). Moreover, earnings growth slowed to the lowest rate in six months (from 2.5% to 2.0%). With Hometrack, the property analytics business, foreseeing homebuyers facing a continued struggle to obtain mortgages in 2011, the outlook for spending and GDP growth looks tough.

Source: Capital Economics “UK Labour Market Data” Regular pay growth slowed from 2.5% to 2.0% (Published end Feb 2011, data to end Dec / Jan)

Consumer Companies Highlight the Headwinds

Highlighting the problem were the many consumer companies missing Q410 earnings estimates and downgrading their forecasts for this year. Diageo, Colgate-Palmolive and P&G were among those that struggled to meet expectations. Falls in demand were blamed, with the situation looking none the rosier going forward. Renault predicts the demand for cars in their home market of France will fall by 8%. In addition, rising input costs is adding to woes. Pepsi is budgeting for a whopping 8 – 9.5% increase in the amount of capital they will spend on oil and agriculture commodities, which contributed to the firm lowering their forecast for earnings growth from low double digits to high single digits. The question on everyone’s lips is – can they continue to pass on higher costs to the consumer? With the aforementioned weakness, the most likely answer is “no”.

Source: Bloomberg. Next share price (white) and the Cotton price (orange) + >10% YTD already.

Inflation ‘Illusion’ Tempting Risky Action

So just how much of a problem is inflation, when compared to the weakness of the recovery? True, headline Inflation has held stubbornly above the Bank of England’s target at 3.7%. However, stripping out food and energy prices, core inflation falls to 2.9% and recent reports show that after excluding taxes, we hit the 2% jackpot. Regardless, the political environment poses a risk. The MPC (Monetary Policy Committee) is under immense pressure to defend its credibility after keeping rates on hold for 23 months consecutively. Markets are now pricing in a 25bps rise in May. Crucially, these expectations alone have consequences. In one week alone, more than 10 mortgage lenders pulled their best fixed rate deals – hitting credit availability to the already weakened consumer ‘spenders’.

Only an idiot fights a war on two fronts. ~ Londo Mollari, Babylon 5

Stagflation – A ‘War on Two Fronts’

This is the crux of the problem – promoting growth can at times risk inflation and fighting inflation can risk weakening growth. Currently the biggest challenge of the two is strengthening growth. If the recovery remains weak, then when inflation rises and poses a far more serious challenge, the government will not be able to implement policies to fight it without dragging the economy into another recession. The possibility of stagflation is real. In this situation the government will feel even more pressure to raise rates but unemployment will still be high and so if rates rise, many will suffer. At the moment the MPC have a “wait and see” attitude – let’s hope this continues and they don’t succumb to ‘peer pressure’ too soon.

The Ags Appeal – Commodities with upside potential leaving demand undimmed…

“If there is no struggle, there is no progress. Those who profess to favor freedom, and yet depreciate agitation, are men who want crops without plowing up the ground.” Frederick Douglass

In an environment of high correlation, where can we gain diversification benefits? And with such a significant divergence of returns within the commodities space, which ones look interesting and why? With so much focus on China, which investment opportunities have the strongest demand outlook?

Correlations High

By the end of last year the 12 month correlation between asset classes had risen to a near record high of almost 0.8 against a historic average of 0.5 (according to Goldman Sachs using data from Datastream and MSCI). Whereas the increase in speculators in the oil market led to the commodity being traded inline with other risk assets, the speculators in the agriculture space (now amounting to around 80% of the market) have continued to trade according to weather patterns.

 

Crude oil price (yellow), commodity index (orange) and the msci world index highly correlated, in contrast to agriculture (green). Source: Bloomberg

 

Attractive Supply and Demand Characteristics

In addition to the portfolio construction benefits of investing in this space, the supply and demand dynamics for certain crops are attractive. 3 years of poor yield (due to weather disruptions) has limited the supply of many. China, the focus on the demand side, has just started to import corn (2 – 3% of total consumption but the beginning of a trend) and signed a $1.8bn deal to import soya beans from the US. How strong is this demand? The USDA (United States Department of Agriculture) reported that despite increases in the price of corn, consumption will be left “undimmed”. With the EU proposing to loosen import restrictions, the case strengthens. Moreover, in addition to having a limited “shelf life”, the capacity for storeage is limited. India left a third of their food to rot last summer due to this fact.

Less Downside Risk to Demand

Finally, comparing the demand dynamic with that for certain metals highlights another key point. Keeping in mind the already high inflation figures coming out of EM (suspected to be higher than published figures in certain cases), some countries will be under pressure to reign back infrastructure spending which would dampen demand for commodities used in construction.  However, with China having 14 million new mouths to feed each year (more than twice Ireland’s population), the question is do you think the higher risk is that China will cool their economy or let any of their people starve?

THE INVESTMENT INSIGHT

In addition to price targets, pay close attention to supply, demand and correlation characteristics of individual commodities. For example, sugar is now trading with a substantially higher degree of correlation to oil and equities – implying it is now perceived as an “energy commodity” with the significance of its use in ethanol production. In contrast to passive, energy focused ETFs, actively picking commodity exposures (or investing with a manager that does so) seems a smart idea. Despite the strong rally so far, agriculture exposure remains attractive…

Commodities – Looking for diversification? Your search doesn’t end here!

Wide diversification is only required when investors do not understand what they are doing – Warren Buffett

The above quote is a key support for my view that investing in index-wide vehicles is merely an exercise in di-worse-ification. It’s time to get specific. Commodities have often been lauded as a “key diversifier” but within the last 18 to 24 months, the case has broken down. Investors using commodity ETFs to enhance the risk-adjusted return of their portfolios may be falling foul of Buffett’s quote. Here I provide a warning to those who may be taking on more risk in their portfolios than they realise…

When constructing a portfolio, diversification is a key focus. Capital is allocated across asset classes in an attempt to produce an attractive risk / return profile. The search is made for investments which post returns completely uncorrelated to other investments, thus helping reduce the volatility of the portfolio since at times when one market may be experiencing a pull-back, another may be exhibiting strong returns entirely unaffected by the input moving the first market.

Historically the commodity markets have been used as such an asset class. An essential ingredient to a well-diversified portfolio, especially one heavily invested in equities. The commodity markets were used mainly by commodity producing companies to lock-in the price for their output (by taking the other side of the trade using options) and enable management to budget adequately.

However, recently this relationship appears to have been contaminated. In speaking to George Zivic (Managing Partner of Almanac Capital) to get a better insight, he maintained that this is a structural change. The increase of investors speculating in the commodity markets has led to a higher percentage of the traders treating the instruments inline with any other risk asset.

Source: Bloomberg. The price movements of the S&P Index (white) and the S&P GSCI Commodity Index (orange), a composite index of commodity sector returns. Note the recent high correlation highlighted in blue

As you can see from the above the movements in the price of the US equity index and that of the commodity index have exhibited a heightened level of correlation.

Furthermore, as you can see from the below chart, the differential between the winning and losing commodity returns has been a great trade for an investor wishing to minimise net exposure to a highly volatile market

 

 

Source: Capital Economics. Selected Commodity Prices in 2Q10 (% Change, $ terms). Note the dispersion in returns, again highlighted in blue.

INVESTMENT INSIGHT

It is no longer the time to gain exposure via passive investing / ETFs etc. The smart money will be making smarter investments – DIFFERENTIATE between commodities, with their different supply / demand characteristics – again, EXPLOIT CONTAGION when some will be over-punished or over-pushed. With the majority of an “all-commodity” ETF invested in the energy markets, at least for the short term alpha generation will focus on the markets with far less visibility, less research focus and less investor attention. “Niche”-type investments in weather derivatives, agriculture etc. offer less correlated returns and greater diversification benefits.