Commodity Market: Tough times call for diversification

While many question the status of the commodities as an investment class, an

economic recovery is expected to give them an instant momentum.
We asked two
commodity experts to share their views on different commodities and how the investors should approach the commodity market in the current economic scenario

Issues

There are no formulae to say that commodities have the same relationship with other asset classes . Gold prices in India may remain up for the next quarter, but a reversal in the rupee could stall the rise. The global economy has a long way to recover that can be seen from the consumer confidence. Despite all this there is one thing which is witnessing record highs and commanding the headline space almost on daily basis is gold which is widely perceived as the leader of the asset basket called “commodities” .

Commodities is a wide term with an investment perspective as the fundamentals that drive commodities are quite diverse. The correlations of various commodities with other asset classes such as equities tend to change from time to time, which makes it much complicated to find the right balance while doing a diversification strategy.

Broadly while commodity prices are driven by two factors which are ‘demand’ and ‘supply’ , like in case of any other asset class, there are numerous factors which impact the demand-supply equation of a particular commodity. Climatic, geographical, transportation related issues add to the dynamics of the demand-supply balance.

Keeping all the above factors in mind, the investor has to strike a balance in the commodity basket by which he is looking to diversify his portfolio and periodically should be changing weights or commodities to incorporate the changes occur in the fundamentals.

It is believed that commodities and equities are inversely correlated, at times it doesn't work. For example, if we take crude oil, the relationship with equities works in a tricky way. At the start of the last bull run in equities, the relationship was perceived to be inverse, due to fears of inflation caused by higher crude oil prices.

However, by the end of bull trend, the relationship turned positive as rising markets and growing GDP numbers indicated a rising demand for crude oil. Now when we stand amidst a global recession, the positive correlation seems strengthening as struggling global stock markets and sluggish growth numbers point towards shrinking crude oil demand world wide. This explains that there are no set formulae to say that all commodities at all times have the same relationship with other asset classes.

The current scenario reflects falling worldwide demand. While India and Chinatwo major engines of world economy—could continue to put up some demand, the negative demand growth in many other economies will continue to put pressure on most of the commodities, especially the base (industrial) metals. Crude oil demand is primarily driven by the economic cycles. While the supply side is considered quite price elastic, the demand side is largely dependent on economic growth.

The demand for refined products like gasoline in the world’s largest consumer US is down by more than 35%. Hence, the demand for crude and products will not be able to push the crude prices above $50-55 mark.

Agricultural commodities will have mixed trends. Sugar prices could remain upbeat this year due to an expected global deficit of around 10.4 million tonnes. For soybean, prices are expected to remain under pressure due to an impressive demand outlook.

The global edible oil demand is expected to fall by 10%, primarily as the demand for bio-diesel has dried out. The cattle numbers are also down by around 12% from last year weighing on the soy meal demand by 10-15 %.

For gold, the prices are expected to stay firm till the investment money finds any other asset which promise to provide some returns. Considering the developments in the global financial markets, such a shift may not take place before the last quarter of 2009.

The domestic prices of gold in India may continue to make new highs for the next quarter, but a reversal in the rupee which might be there in the second half of 2009 could stall the rise in prices here.

Traditionally portfolios which are well diversified among different asset classes have shown more predictability and stability of returns. However , in India the trend of diversification in to commodities has not picked up unlike the developed economies.

There are primarily two reasons for this: the first is lack of knowledge of the retail investors. The commodity futures markets are very complex and the investments in these markets have to be managed by professionals. Second: the funds are not allowed to invest in the domestic commodity markets.