Commodity Markets Using A Macro Framework

Lately, I have been to many commodity related conferences and there are a few things to point out:

• Many people who attend dont know much about commodities (and are thus keen to learn more about them)
  
• Conference organisers often tell money managers that commodities are an essential part of a diversified portfolio
• We are in a commodity super cycle
• Speaker often confuse attendees with useless information

Hopefully these next few arguments will shed light on the bullet points above.

Firstly, commodity markets are subject to supply and demand dynamics. Like other goods they are relatively scarce or abundant, and this helps determine the price. Commodities are widely traded and are thus pretty liquid instruments, especially front month contracts (1st month futures contract). Having said that, from what I have understood, supply and demand dynamics work in different ways during different types of markets. For example, in a bull market, commodity groups (base metals, agricultural softs or grains, and precious metals) will move together, and some of the individual commodities are substitutes to one another. Here, supply and demand dynamics play a key role, as supply or demand shocks, such as a poor harvest in a producer country or a government policy aimed at increasing its inventories can have strong positive shock on the price. While the same dynamics work in a bear market, they have less of an impact. bear markets are often unexpected, the decline in prices accross all assets has the effect of forced deleveraging. This impacts all commodity groups, although there are some difference depending on how abundant supplies are. Secondly, global real GDP will give you a key indication of where commodities will head next. If you see the global economy slowing, then it is likely that commodities prices will also likely decline. Thirdly, one must take exchange rate effects into account. A stronger US dollar, usually implies commodity price weakness, at least in the short term. Fourthly, investor positions also matter as institutional investors can help increase prices as they can cause them to decline by selling assets at a discount, or in a firesale.

The point I am trying to make here is that we have to look at commodity markets in a wholistic sense. Much like good equity analysts, they dont only look at the stock price/cashflow etc in isolation from everything else and must take global economic trends into account. The current economic environment is testament to this. So for people who dont understand commodities, this, i find is the most consistent and balanced approach.


Balanced Portfolio
Commodity markets have become increasingly important in portfolios. They are often cited as not being very correlated to the movement in stock prices and will never go to zero. Furthermore, they are generally liquid contracts, although if you re trading futures you must roll them over and the cost of carry can be expensive (derivative products get round this). I personally find that commodities are correlated to the business cycle, and in a very strong fashion. While they may one of the latter shoes to drop, if this economic and financial fall out teaches us anything, it is that commoditis are correlated with the business cycle.

Commodity Super-cycle
I Buy this argument. I mean, unless supplies and inventories increase quickly, then inventory levels for a majority of these commodities remain low by historical standards. While growth is slowly rapidly, and this will weigh on prices and demand, incentives to increase production also decline. Should a pick up in global economic activity coincide with low inventories, then prices will rise and they will rise fast!


Speaker Confuse Attendees
I find that often, speakers dwell too much on small details, and dont get the whole big picture. One must understand this before looking at the details.