Which Commodities Work Now?

|
Includes: DGL, IAU, SLV
by: Hard Assets Investor

The frequency and size of losses from financial institutions is increasing daily, with almost $50 billion raised recently to shore up balance sheet problems. With the reverberations of the subprime crisis being felt around the world, equity markets have shown massive volatility and significant falls in the order of -10% to -20% in the past six weeks.

Additionally, U.S. and U.K. real estate have a somewhat negative-to-neutral outlook after a long bull run, while some hedge funds have frightened some investors because they are often highly correlated during non-normal markets.

In times of stressed financial markets, particularly when equities have performed poorly, commodities have tended to outperform. On average, commodities showed a positive 12-month return 70% of the time when equity returns were negative. Additionally, in the worst months for equity returns, commodities outperformed by up to 6% per month.

The chart below shows the average daily returns over the past 10 years during the worst times for equities. It shows that regardless of which equity index you chose, the daily returns of commodities outperformed by up to 2.5% per day. On a monthly basis, the average outperformance was approximately 6%.

The question is, what will happen now?

$100 oil and $1,000 gold has started to get people's attention, but the fundamentals of many commodity sectors remain strong. But while commodities tend to have positive returns during equity bear markets, some sectors may not perform as well as others during U.S. and global economic recession; particularly industrial metals and oil. However, the following sectors appear to have robust fundamentals:

Grains – Despite performing well last year, the underlying fundamentals of the grains complex including wheat, soybeans and corn remains strong. Demand growth continues with emerging country incomes rising, resulting in increased meat consumption and thus demand for animal feed such as soybeans. Corn-based ethanol production continues to rise while global stocks of wheat, corn and soybeans continue to fall, especially wheat, which was severely affected by bad weather last year.

Softs – Softs performed poorly last year, but many analysts expect that trend to reverse in 2008. Demand for cotton is expected to increase on the back of higher synthetic prices (a substitute for cotton), higher emerging market incomes (allowing demand to switch to higher-cost cotton fabrics) and potential crop rotation from cotton to corn. Coffee is also showing robust demand, growth especially in low-consumption markets. Sugar has suffered from oversupply, but with the investment rotation from grains to softs, substitution of corn-based syrup to sugar and increased demand for sugar-based ethanol may support sugar prices in the coming year.

Precious Metals – The gold, silver and platinum markets remain relatively tight, while the current U.S. economic situation is putting pressure on the U.S. dollar. Additionally, the global subprime crisis is causing a flight to safe-haven assets, and falling U.S. interest rates which are also positive for gold. If this scenario continues, expect precious metals to get pulled along for a golden ride. The possible exceptions include palladium, where higher supplies may mean flat or lower prices.

Until recently, direct investment in commodities was the realm of sophisticated speculators and producers who either traded via bespoke agreements or on futures markets. The advent of exchange-traded commodities [ETCs] now provides investors direct and low-cost access to the commodities markets.

The chart below shows the correlation of various commodity and equity benchmarks with the FTSE 100 and S&P 500.