Time for a contrarian bet on commodities?

24th November 2013

In theory, this should be a bumper time for certain parts of the commodities market. With the economic recovery underway, the return of corporate capital spending should be providing a much-needed boost for the unloved sector. However, commodities prices remain stubbornly low and there has been no discernible turnaround in performance for natural resources funds. With a number of multi-managers now returning to commodities, is there anything that suggests brighter prospects for the sector? Investment journalist Cherry Reynard reports.

Graham French’s departure from the helm of M&G Global Basics had an ‘end of an era’ feel to it. French had long been a champion, and beneficiary, of the bull run in natural resources as emerging markets. His departure coincides with a change in sentiment towards the sector over the past three years.

There are other things that suggest bearish sentiment towards commodities has reached its peak, the much-debated ‘capitulation’ point for contrarian investors, when the fortunes of an asset begin to turn. For example, Morgan Stanley looks to be close to unloading its commodities platform – as the New York Post reports – a key sign that investment banks have grown disillusioned with the sector.

When Cazenove multi-manager Robin McDonald announced recently that he was buying back into commodities – reported on trade paper FtAdviser – he said that commodities had become: “the most popular short among hedge funds and the most underweight sector in the long-only community.

“They have dramatically underperformed, they are undervalued, under-owned and unloved, and those are the types of things we find interesting.”

McDonald is buying commodities as a good contrarian play and as a way to tilt the portfolio to more economically sensitive areas, but he is not the only Cazenove manager showing an interest. Matt Hudson, manager of the Cazenove UK Equity Income fund, is also taking positions in cyclical companies as he sees the business cycle moving to favour more late-stage industrial and commodity cyclical companies.

“As consumers consume more goods and services, capacity runs out and companies have to build to deliver more capacity and therefore it feeds into the capital expenditure cycle. There is a natural progression and it makes sense to be shifting from consumer to industrial and commodity cyclicals. The market has disliked these stocks for a long time and in many cases they now look very cheap,” he says.

But while this is good in theory, is there any sign of a revival for commodities in practice? Certainly, improving economic data has yet to feed into commodities prices. Oil and gas have moved a little higher recently, but only in line with global equity markets. Precious metals such as gold and palladium, and agricultural commodities such as wheat, corn and cotton are trending downwards. There are some signs of life in commodities markets such as cattle and cocoa, but these are the rare exceptions.

Equally, there is no nascent improvement in the performance of funds in the natural resources sector. In the sectors in which they appear – global and specialist – they cluster at the bottom of the tables over one and three years, but even over shorter time periods such as one and three months.

That said, there are very tentative signs of stabilisation in the share prices of natural resources companies. The basic resources sector has started to move higher over the past month. The commodities team at Investec says: “Resource equities performed positively in October, despite the mixed performance of physical commodities. Positive economic data from China and the US supported investor appetite for the sector, outweighing the impact of a less dovish policy outlook from the US Federal Reserve (Fed). The MSCI AC World Select Natural Resources Capped NDR Index increased 2.9% while the Dow Jones UBS Commodity Index declined 1.5% over the same period. Energy equities performed well during the month, in contrast to physical oil prices, as shown by the MSCI AC World Energy Index, which rose 4.1% over the month.”

In other words, the share prices of mining and resources companies are outstripping the prices of the underlying commodities. Ani Markova, manager of the Smith & Williamson Global Gold and Resources fund, says that gold mining companies have had to adjust their cost base for a new, lower gold price. If there is any expectation that the price of gold – or other commodities – could rise, the better companies that have got their structure in order look very lowly valued: “This sector looks very oversold and very cheap….mining is a very long cycle business and can’t turn on a dime. There are now good opportunities where companies have been significantly mispriced” she says.

A similar phenomenon is being seen in other commodities sectors – agriculture, for example. BlackRock’s Desmond Cheung, co-manager on the BGF World Agriculture fund, points out that a lot of companies in the sector have undergone deep cost-cutting to survive and lower crop prices could now become a tailwind for them as Citywire reports.

The Investec team says that, for the time being, optimism around strong Chinese manufacturing and import data is being tempered by concerns about the US, but base metal & bulks equities are performing better due to stronger global demand. Forward looking data such as energy demand is generally positive. They add: “We continue to see a number of energy equities trading significantly below the current oil price and if prices remain strong, we would expect to see energy equities rally.”

This environment of low rates, loose money and economic expansion should suit commodities well. If inflation starts creeping in, so much the better. It is a contrarian bet, with only nascent signs of a turnaround in the market, but the true contrarian always buys when it’s uncomfortable.

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