Overview And Recommended Asset Allocation
Argus offers its assessment of real assets, within a two-part series. The first part is focused on the overall environment for real assets, currency sensitivity and real estate. The second part of our series will focus primarily on commodities.
Summarizing our conclusions within a few bullets points, we make the following observations:
· For balanced accounts, we would allocate 5% of investments into real assets, split as follows:
o 1%-2% in real estate
o 3%-4% in commodities and non-equity energy
· We would focus on commercial real estate, based on our view that the professional-investor phase in residential real estate is ending.
· For the intermediate-term, we are encouraged by signs that commodities have come off their lows, despite the negative of the currently strong dollar.
· For the long-term, we believe that commodity demand drivers will remain intact and that a weakening dollar will support commodity prices.
We recommend that investors allocate 65% of their investments to equities, with approximately two-thirds in large-cap names and one-third in mid-sized and smaller names. We also recommend 25% exposure to fixed income, while being mindful of the risks in that forecast based on the prevailing trend (upward) in interest rates.
For the remaining 10% of investments, we would recommend an even split of 5% each to cash and to real assets. Variously called non-traditional or alternative assets, real assets would include gold and other precious and base metals, industrial and agricultural commodities, non-REIT real estate assets, and non-equity energy assets.
Is there such a thing as a commodity "super-cycle," and does it drive investment patterns in hard assets? Perhaps more important, and assuming they are real, do prior cycles tell us anything about the current trend in commodities?
Columbia University's Bilge Erten believes the global economy is in a global commodity super-cycle that dates from around 2000. According to his model, the current super-cycle could go on to 2015 or beyond. Professor Erten has identified three prior commodity super-cycles. These prior cycles peaked in 1917, 1951 and 1973.
All three prior cycles coincide with heavy materials demand from wartime or post-wartime rebuilding. Bilge Erten joins a few other economists who believe the current "super-cycle" began in 2000. This cycle is not associated with any materials-hungry war. However, it is associated with China and what has been its voracious appetite for raw materials to fuel its industrial growth. Given China's malaise and faltering demand, some economists assume that any such post-2000 "super-cycle" has now ended or is ending.
Our Perspective on Super-Cycles
We are wary about declaring a commodity super-cycle. From an investment perspective, we note that super-cycles are usually identified not in real time but only in the rear view. Moreover, we are wary about becoming calendar-reliant, for instance determining that any current cycle should end in 2015 because that matches the prior pattern.
In our view, expansion in China and in emerging economies in general represents a new and persistent phenomenon. We do not think this expansion, uneven as it sometimes is, lines up well with the hyper-demand phase generated on a transitory basis by war. In our view, growing demand for commodities reflects the potential for adding one to two billion middle-class consumers from emerging economies in the next decade.
Commodities: Multi-Decade Outperformance
Since 1980, commodities including energy have significantly outperformed stocks and fixed income investments in the United States. Reaching back just as far as the millennial turn, from 1/1/2000 through mid-year 2013 key commodities delivered performances that were much better than stock- and bond-market performances:
· Gold: +328.2%
· WTI: +284.9%
· Wheat: +164.6%
· Dollar index: -19.2%
· 10-year treasury yield: -61.2%
· S&P 500: +9.9%
(Source: Federal Reserve Bank of St. Louis)
Commodities: Recent Underperformance (Except for WTI)
In the past year, however, commodities (excluding energy) have lagged stocks and fixed income investments in the United States. As of 8/22/13:
- S&P 500: 16.4% appreciation (18% total return)
- PPI Industrial Commodities: 1.1%
- PPI All Commodities: 1.0%
- Fed Rsrv St Louis WTI: 15.0%
- Import End Use: All Commodities: -0.7% (through 7/1/13)
- Import Price Index China: All Commodities: -1.0% (through 7/1/13)
Why the Recent Underperformance?
We see a range of reasons driving the recent underperformance in commodities. These include weaker economic fundamentals in many of the commodity-consuming economies; rising interest rates and disrupted currency markets.
The major commodity-consuming markets are led by China and other emerging manufacturing nations. The reset in China's leadership late last year resulted in efforts to rein in the banking system, eliminate "shadow" banking, and cool the overheated housing sector. This has hurt overall economic activity.
Any weakening in demand from China and from other productive economies in Southeast Asia impacts the resource economies, both mature and emerging. So far in 2013, the two major developed resource economies (Canada and Australia) and the three major emerging resource economies (Russia, Brazil and South Africa) all have negative stock-market performances. This reflects the poor overall level of economic activity in these nations.
Among the traditional industrial power, the U.S. remains in a persistent but low-grade recovery. Europe appears to be stabilizing, but at a very low level. Japan used aggressive quantitative easing to deliberately slam the yen in hopes of better competing with Korea and China. That does seem to be working. But since the yen collapsed, commodity end markets have been in turmoil. For example, CRB metals prices were down 9% from February through April 2013.
Argus Intermediate And Long-Term Perspective on Commodities: Positive
While the concerns stated above are real, investors may have under-estimated some of the positive developments related to the global economy. In our view, the slowdown in China and in emerging Asia is overstated. Recent data out of China, including the purchasing mangers index (PMI) and industrial activity reports have been positive. In China, for example, the July data showed production up 9.7%, retail sales up 13.2%, and real estate and fixed investment growing at 20%-plus rates.
As we have noted, dollar strength is often associated with commodity price weakness (given that most commodities are priced in dollars). On either a broad-weighted or major trading partners-weighted basis, various measures of the U.S. dollar have pulled back. After its plunge, the yen is showing a tentative recovery. The euro has also strengthened. Moreover, our long-term assumption that the dollar will weaken remains intact. Argus Chief Investment Strategist Peter Canelo believes the dollar can go much lower over time, which would benefit commodity prices
Industrial commodity prices have firmed across the summer, quietly rising off their lows. As of late August, CRB Metals prices were up 7% since low in June, and up 12% from the mid-2012 low. CRB Raw Industrials were also up 7% from their lows.
We continue to assume that QE tapering both here and abroad will usher in a period of higher rates. In such an environment, we would expect some measure of inflation. And in inflationary periods, hard assets are coveted as a value-holding source of "wealth in the ground." Our expectation is that inflation will increase, which historically has benefited hard assets such as oil, metals and agricultural commodities.
A final reason to like commodities in this environment is as a contrarian play. After years in which "everyone" cheered for rising commodity prices, "everyone" now knows the super-cycle is ending. We are not convinced there is a super-cycle. In any event, we do not expect commodity demand to end because of a calendar predication. When the market becomes too bearish on commodities, that creates room for sentiment reversal.
Specific Commodity Asset Forecasts
- Gold equities hurt by over-investment in new sites and mines
- That led to over-production relative to underlying demand from ...
- Decorative, central bank, industrial (now small)
- Price largely driven by two recessions, particularly gloom and doom following 2008 recession and sense of unending QE
Industrial Commodities And Metals
- China has had its "shake-out" following the leadership change late last year
- Efforts to stabilize banking system, reduce speculative excesses
- We expect recovering demand in China to lead to continued recovery in industrial commodity prices
- European recovery led by Scandinavia, UK, Germany
- US in low-grade by persistent recovery
- Copper OK; for steel, track auto/construction demand
- U.S. in rare role for industrial economy as global "bread basket"
- More normal weather in Midwest (after 2012 drought) has sent corn prices down 40%
- Expect bumper wheat crop as well; wheat down 16% in past year
- Channel Check: California Central Valley blooming despite drought
- Avoid agricultural commodities until prices flatten/bottom
· We believe that the price of WTI will come down from its current levels over $105 per barrel (YTD average for WTI is $96.63)
· E&P companies are ramping up production in unconventional U.S. plays
· Crude supply trends are increasing, putting downward pressure on prices for the remainder of 2013
· Crude demand reflects teetering balance of
o emerging economy acceleration
o mature economy eco initiatives (less coal, Prius, solar, etc.)
· Natural gas prices will remain depressed due to lack of catalysts in near term
o Would be more inclined to play favored equity sub-sectors (select E&P) rather than participate in energy futures/physical
(Jim Kelleher, CFA, Director of Research)