A few years ago, Tom Fernandes was working as an equities trading and analyst in New York. One day, he happened to read Jim Roger's book, Hot Commodities, and it struck a chord.
"As soon as I put down the book, I turned to my wife and said, 'I've got to get into commodities,'" says Fernandes.
On a trip to Atlanta, he met up with Ashmead Pringle, the founder of Grain Services Corporation and an expert in commodity futures. He eventually took a job with Pringle, and they have worked together on a variety of projects, including launching the GreenHaven Continuous Commodity ETF (NYSE Arca: GCC).
He spoke with HardAssetsInvestor.com about the outlook for commodities.
HardAssetsInvestor.com [HAI]: Given the huge volatility in commodity markets over the past year, what do you say to an investor who's wondering if they should make an allocation to commodities in their portfolio?
Tom Fernandes, director, GreenHaven Commodity Services (Fernandes): There are probably a few reasons to own a commodity index product. One of those reasons is the possibility for inflation or unanticipated inflation, which could wreak havoc on your purchasing power over both the short and long run. I know a lot of investors are looking at their equity portfolios right now and seeing that they have been flat or down over the past 10-20 years. The dollar is off about 40% over that time, and that hits home. They're not keeping up with inflation.
I think equities are a core holding for most portfolios. But over both the long term, and more specifically over the past 5-10 years, having something that's less correlated with equities and that is positively correlated with inflation would have made a lot of sense. Yes, commodities are down: the product I manage, the GreenHaven Continuous Commodity ETF (NYSE Arca: GCC), is down about 35%; the DJ-AIG Commodity Index is down about 45%, and the S&P GSCI is down more than that. But if you have a long enough holding period [the benefits reveal themselves].
HAI: But what about an investor who's looking at this terrible economy and thinking, there's no demand for anything right now. How can commodities possibly be a good idea?
Fernandes: It's an interesting question. There's a Yale study that's often cited for justifying commodity investments. It shows an interesting thing about commodities and the business cycle.
If you go back from 1959 to 2004, the overall inflation using the Consumer Price Index was about 4.2%. In an expansionary business cycle it was about 4%, and in a recessionary business cycle it was about 6%.
In other words, when we're in a recession, inflation using CPI has been 20-50% higher than during expansions. It's a little counterintuitive, but it makes sense in one way. We've seen this before: One of the ways you get out of a recession is with some inflation. That may be caused by central banks printing money, which you're certainly seeing now. And it's showed up historically in the data. It will be up to the investor as to whether they think commodities will reflect a positive performance compared to other things in this kind of environment.
HAI: Is there any one piece of the commodities market that looks better than the others?
Fernandes: When you go through and break down commodity sectors over early and late recessionary periods, you notice some interesting trends. I don't think anyone can come out publicly and say we're in an early or late recession, but the Yale study shows that in early recessions, energy products have done pretty well. In fact, it's entirely possible that many recessions are actually brought on by high input costs from the energy. In each recession that has occurred from 1959 to 2004, we saw high energy prices heading into the early parts of the recession.
In a late recession, most but not all energy gains are given away. Historically, crude oil total returns are up about 30% in an early recession, and then give back about 26% of those gains in a late recession.
The ags perform differently. Corn is typically down 4% in an early recession, but it's up 9% annually in a late recession and up 14% in a late expansion. I won't go through all the commodities, but you find some interesting divergences that have happened over many, many business cycles. Sugar typically does really well in an early recession, rising 54%, and it doesn't give up those gains in late recessions, when it rises 24%.
We don't think you can take these ideas to the bank and assume they will happen. But we do think that it's fair to say that commodities like copper and cocoa have a low correlation to each other, and that the business cycle trends that influenced them in the past are likely to affect them in the future.
HAI: Are there any outside-the-box developments that investors should be keeping an eye on?
Fernandes: Well, we're pretty deeply involved in grains from the physical side of the market. And one of the things that we've been thinking about in grains, which doesn't necessarily get followed by the general investing public, is the possibility of macro global developments being a shock to the grain market. And we happen to think that there's more risk to the upside than the downside if a shock occurs.
HAI: Like what?
Fernandes: The only downside shock we can think of is a bird flu pandemic. A bird flu pandemic, which could happen, would be terrible news for grains, as it would directly impact demand.
But a more realistic probability from a macro perspective is what you're seeing in Argentina. Argentina is the No. 3 supplier of corn to the world, and it's in the process of nationalizing its grain business. At the same time you have China, the largest swing consumer in terms of protein consumption per capita, building stockpiles of food and taking bulks shipments of food. So we think that the grains have some macro and geopolitical forces at play that could really impact them to the upside.
We've seen this happen before with governments hoarding food. Eighteen months ago, Korea was buying much of its corn from China. China made a decision it was not going to export corn anymore, and Korea had to find another producer, which was the U.S. and Argentina. That pushed up prices here.
HAI: So you're bullish on grains?
Fernandes: Yes. And the other thing we've been thinking about grains recently is that they're one of the best ways to play water. About 75% of the world's fresh water gets used for ag production. We've seen a lot of investor interest in the water ETFs: the funds that track water utilities and water technology companies. And we agree that water is an important investment theme.
But we think grain may make a good proxy for water. If the cost of accessing water goes higher, it directly feeds into the cost of agriculture. If you happen to be bullish on water, tilting to agriculture makes sense.