After doubling since the Covid crash of 2020, commodity prices have recently fallen 20% from their highs as investors become more concerned about the possibility of a global recession reducing demand for commodities. Therefore, it is an ideal time to buy raw materials. Today we are going to give you a little lesson for your training in investing in raw materials. We have three reasons why you should consider taking advantage of the decline and adding commodities to your portfolio…
Raw materials add strength to our portfolio.
One of the fundamental pillars for our investment training is to diversify our portfolio, especially when the economic environment is uncertain. The problem with investing only in stocks and bonds is that, to achieve good results, both need low inflation. This is because when inflation is high, central banks tend to respond by raising interest rates. And those two factors (growing inflation and further increases in interest rates) decrease the "real" present value of the future cash flows of both asset classes. This has been seen throughout the year. With inflation high and the Federal Reserve raising rates, stocks and bonds have struggled.
Comparison of profitability of raw materials (blue), stocks (yellow) and bonds (red). Source: Tradingview.
Fortunately, commodities address that blind spot in our portfolio. As we told you in another lesson commodity investment training, oil, gas, metals and agricultural products thrive when inflation is high and interest rates rise, as they have all year. This is partly because commodities are real assets with intrinsic value. But it is also because they are often at the center of what drives inflation, since they are the engine of almost everything that is produced. In other words, when inflation rises, it is because commodity prices are rising.
Its supply is scarce and its profitability is really tempting.
Over the past decade, commodities have seen years of little investment in production capacity. Spiraling disruptions from the pandemic and the war between Ukraine and Russia have driven raw material supplies to incredibly low levels. And with no quick fix in sight, lack of inventories will keep prices rising as people rush to buy essential goods, fearing shortages or depletion. More importantly, this low supply forces buyers to pay a premium if they want to ensure delivery in the near future. This causes the price of short-term contracts to be higher than that of long-term contracts, in a situation known as "backwardation«. Backwardation means that long-term commodity investors can buy them at a discount and earn a nice extra return called “backwardation returns.” This additional return means that commodity investors can generate a good return even if the price of the commodity does not change much.
Backwardation explained. Source: Rankia.
It is a good long-term investment.
We are likely witnessing the beginning of a “commodities supercycle,” that is, a period of rising prices with strong demand that typically lasts more than a decade. The new era of rising interest rates coupled with high inflation is likely to continue to grow. As investors, governments and businesses refocus on the economy (such as infrastructure, manufacturing and real estate), demand for raw materials should continue to grow, along with their prices. The satisfaction of all that demand will not occur immediately. In previous years, with lower prices and strong regulatory pressures, investment in production and their respective production rates decreased. So it could take years for supply to meet growing demand, causing prices to continue rising in the meantime.
Expected growth in demand for raw materials until 2040. Source: Wood Mackenzie.
How do we take advantage of this investment opportunity?
Since the collapse suffered during the pandemic, commodities have since gained 78%, while stocks have only risen 7%. Even after such a strong rally, we continue to believe that commodities have an attractive risk-reward profile at these levels. Of course, there are short-term risks. A global recession that could seriously reduce demand for raw materials, for example, or a much-needed solution to the energy crisis in Europe. The conclusion we draw from this investment training is that those who want to build a long-term balanced portfolio, it is essential to have raw materials, and any drop is an interesting entry point.
There are many ways to invest in commodities, but one of the best is abrdn Bloomberg All Commodity Strategy K-1 Free ETF (BCI). It is the cheapest liquid ETF and is well diversified. For European investors, the L&G All Commodities UCITS ETF (BCOG) is a good bet. This fund tracks the Bloomberg Commodity Index and provides us with diversified exposure to the energy sector, precious metals, industrial metals, livestock, grains and soft commodities.