Hot Commodities. As many emerging economies industrialize, increase their use
of energy, and enhance their diets, the demand for the commodities used in.
Hot Commodities An In-depth Update on the Commodities Market by Tim Leach, Chief Investment Officer with U.S. Bank Wealth ManagemenT
A
s many emerging economies industrialize, increase their use of energy, and enhance their diets, the demand for the commodities used in agricultural and industrial applications is likely to experience sustained growth. From October 2010 to October 2011, for instance, crude oil has shot up by 22.3 percent, pork by 30 percent, rice by 12.9 percent, and steel wire by 19.7 percent according to Index Mundi. Most commodities have fallen recently due to slower economic growth projections for 2011 and 2012 and due to the stronger dollar—the price of commodities and the U.S. dollar tend to be inversely correlated. Commodities may play an important role in providing diversification and potential inflation protection, when included appropriatly within a sophisticated investor’s wellHot Commodities balanced portfolio. We believe generally higher A commodity prices are likely to continue over the intermediate and longer term given the anticipated growth in demand for almost all types of commodities. Global energy demand is forecast to increase by 36 percent between 2008 and 2035, according to the International Energy Agency’s “World Energy Outlook 2010.” Almost all the rise in demand is expected to come from emerging economies. China alone accounts for more than one-third of the projected growth in global energy use; its demand is predicted to rise by 75 percent between 2008 and 2035, according to the World Energy Outlook. Similarly, demand for agricultural products from developing countries also is rising. In his 2010 study, “Demand Growth in Developing Countries,” David Abler, a professor at Penn State University, examined five large developing economies: Brazil, Russia, India, Indonesia, and China. Based on his research, Abler reached the following conclusions, among others: Future growth in per-capita food demand for beef is likely to be significant in Brazil, India, and Indonesia; for dairy products, future growth in demand is likely to be significant in Brazil, Indonesia, and especially China. Along with growing demand, the languishing U.S. dollar also has had the effect of boosting commodity prices. Many web eXcLUsive
An In-depth Update on the Commodities Market
by Tim Leach, chief invesTmenT Officer wiTh U.s. bank weaLTh managemenT
s many emerging economies industrialize, increase their use of energy, and enhance their diets, the demand for the commodities used in agricultural and industrial applications is likely to experience sustained growth. From October 2010 to October 2011, for instance, crude oil has shot up by 22.3 percent, pork by 30 percent, rice by 12.9 percent, and steel wire by 19.7 percent according to Index Mundi. Most commodities have fallen recently due to slower economic growth projections for 2011 and 2012 and due to the stronger dollar—the price of commodities and the U.S. dollar tend to be inversely correlated. Commodities may play an important role in providing diversification and potential inflation protection, when included appropriatly within a sophisticated investor’s well-balanced portfolio. We believe generally higher commodity prices are likely to continue over the intermediate and longer term given the anticipated growth in demand for almost all types of commodities. Global energy demand is forecast to increase by 36 percent between 2008 and 2035, according to the International Energy Agency’s “World Energy Outlook 2010.” Almost all the rise in demand is expected to come from emerging economies. China alone accounts for more than one-
12
WINTER 2011/2012
Reprinted from the Winter 2011/2012 issue of Reserve magazine
third of the projected growth in global energy use; its demand is predicted to rise by 75 percent between 2008 and 2035, according to the World Energy Outlook. Similarly, demand for agricultural products from developing countries also is rising. In his 2010 study, “Demand Growth in Developing Countries,” David Abler, a professor at Penn State University, examined five large developing economies: Brazil, Russia, India, Indonesia, and China. Based on his research, Abler reached the following conclusions, among others: Future growth in per-capita food demand for beef is likely to be significant in Brazil, India, and Indonesia; for dairy products, future growth in demand is likely to be significant in Brazil, Indonesia, and especially China. Along with growing demand, the languishing U.S. dollar also has had the effect of boosting commodity prices.
commodities are priced in dollars, so as the dollar weakens, their prices often rise to offset this decline. For instance, so far this year, the dollar has dropped about 7 percent against the Japanese yen, and about 1 percent against the European euro. Over the past two years, the U.S. dollar has declined by about 10 percent against the Australian dollar. Attributes of Commodity Investments
As an investment, commodities may provide several key benefits. Historically, returns on commodities have had little correlation to other types of assets, such as stocks or bonds. As a result, commodities may provide asset diversification. Conversely, commodity prices generally are correlated to inflation, and thus they may provide investors with a hedge against rising prices. In addition, commodities historically have offered returns similar to equity investments. To be sure, commodity prices can be volatile. While the average annual price gain over the past decade has been about 6 percent, the yearly returns have varied from a 60-percent loss to a 90percent gain. While investors can, of course, hold shares in companies that operate primarily in a commodity sector—say, an oil and gas company—this typically doesn’t provide the hedge against inflation or the diversification that more direct exposure to the commodity itself may. A number of other elements and expenses go into these companies’ performance, blunting the direct impact of any changes in the price of the commodity itself and limiting the stocks’ appeal as a diversification tool. Instead, we believe the most effective way for sophisticated investors to gain exposure to this sector is through futures or vehicles that are exposed to commodity futures. A future is a contract to buy or sell a commodity or investment at a predetermined price, at a set date in the future. For instance, a futures contract might obligate an investor to purchase a barrel of oil in a month for a price of $82. Of course, few investors actually want to purchase a barrel of oil. Instead, most would exit the contract through an offsetting transaction. Often, this means selling their current contract and cOmmOdiTies markeT
Many commodities are priced in dollars, so as the dollar weakens, their prices often rise to offset this decline. For instance, so far this year, the dollar has dropped about 7 percent against the Japanese yen, and about 1 percent against the European euro. Over the past two years, the U.S. dollar has declined by about 10 percent against the Australian dollar. Attributes of Commodity investments
As an investment, commodities may provide several key benefits. Historically, returns on commodities have had little correlation to other types of assets, such as stocks or bonds. As a result, commodities may provide asset diversification. Conversely, commodity prices generally are correlated to inflation, and thus they may provide investors with a hedge against rising prices. In addition, commodities historically have offered returns similar to equity investments. To be sure, commodity prices can be volatile. While the average annual price gain over the past decade has been about 6 percent, the yearly returns have varied from a 60-percent loss to a 90percent gain. While investors can, of course, hold shares in companies that operate primarily in a commodity sector—say, an oil and gas company—this typically doesn’t provide the hedge against inflation or the diversification that more direct exposure to the commodity itself may. A number of other elements and expenses go into these companies’ performance, blunting the direct impact of any changes in the price of the commodity itself and limiting the stocks’ appeal as a diversification tool. Instead, we believe the most effective way for sophisticated investors to
gain exposure to this sector is through futures or vehicles that are exposed to commodity futures. A future is a contract to buy or sell a commodity or investment at a predetermined price, at a set date in the future. For instance, a futures contract might obligate an investor to purchase a barrel of oil in a month for a price of $82. Of course, few investors actually want to purchase a barrel of oil. Instead, most would exit the contract through an offsetting transaction. Often, this means selling their current contract and purchasing another that comes due at an even later date. By locking in a current price, and then selling the contract before it comes due, investors may use futures contracts to benefit from unexpected rises in the price of a commodity. A number of mutual funds, exchange traded funds, and exchange traded notes, as well as private investment funds, are exposed either to commodities futures
or an index, such as the Dow Jones Commodity Index, that is based on pricing in the futures market. These vehicles allow for a direct investment in commodities yet don’t require the investor to incur the costs that would come with actually transporting and storing the oil, grain, or other commodity. Given the historical volatility of many commodity prices, most clients may want to limit their holdings to no more than about 10 to 12 percent of the overall value of their portfolios. Investing in commodities through futures has historically provided the greatest returns during periods of unexpected inflation. The investment managers we work with employ state-of-the-art tools that enable them to follow and act upon trends in commodity prices. Our reports on commodities and other investment vehicles, as well as our regular market update calls, provide clients with additional insight from our investment experts. ■
All thAt Glitters:
Why Gold may not be a shining investment Along with many other commodities, gold has experienced a significant, albeit volatile, increase in its price over the past year, rising about 27 percent, from November 1, 2010, through October 31, 2011, according to Kitco Metals Inc. This jump in the price of gold, along with the commonly held perception that gold provides a safe haven in times of economic uncertainty, has prompted some investors to consider investing in the precious metal. However, while gold has gained a reputation as a hedge against
inflation and a stable store of value, a closer examination reveals that this often isn’t the case. Unlike most consumable commodities, such as oil or soybeans, the price of gold doesn’t follow a typical supply-and-demand curve. Instead, it tends to trade based on investor sentiment. As a result, gold can be an extremely speculative investment. For example, the price of gold fell by about 15 percent between September 5, 2011, and September 26, 2011, but increased approximately 4 percent in the month of October, also according to Kitco Metals Inc.
Investment products, including shares of mutual funds, are not deposits or obligations of, or guaranteed by U.S. Bank or any of its affiliates, nor are they insured by the Federal Deposit Insurance Corporation, or any other government agency. An investment in such products involves risk, including possible loss of principal. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Investments in private equity are illiquid by nature and typically represent a long-term binding commitment. The investments made by private equity funds are not readily marketable and the valuation procedures for these positions are often subjective in nature. Mutual fund investing involves risk; principal loss is possible. Investing in certain funds involves special risks, such as those related to investments in small- and mid-capitalization stocks, foreign, debt, and high-yield securities, and funds that focus their investments in a particular industry. Please refer to the fund prospectus for additional details pertaining to these risks. This information represents the opinion of U.S. Bank and is not intended to be a forecast of future events or a guarantee of future results. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Investments in exchange funds are available to investors who meet “Qualified Purchaser” qualifications. While exchange funds provide diversification, they will not protect against broad market declines. Investors must remain in a fund for at least seven years before redeeming shares and those who leave prematurely may face penalties and only receive their original shares back. For additional details about various risks associated with these types of investments, investors should review the offering materials, including the Private Offering Memorandum for the exchange fund. ETN disclosure -- we haven’t used anything in the past since we don’t have these on the platform. I’ve drafted the following disclosure but you’ll need to run it by compliance for input: Exchange-traded notes (ETNs) are unsecured promises by the issuer to pay a rate of return that is tied to the change in the value of an underlying index. Not only are ETN holders exposed to market risk, they are subject to credit (counterparty) risk. Much like ETFs, ETNs can be purchased and sold throughout the trading day, however, there is no guarantee that the market price of an ETN during the trading day will reflect the change of the underlying index or commodity, thus opening the door for tracking error.
13
purchasing another that comes due at an even later date. By locking in a current price, and then selling the contract before it comes due, investors may use futures contracts to benefit from unexpected rises in the price of a commodity. A number of mutual funds, exchange traded funds, and exchange traded notes, as well as private investment funds, are exposed either to commodities futures or an index, such as the Dow Jones Commodity Index, that is based on pricing in the futures market. These vehicles allow for a direct investment in commodities yet don’t require the investor to incur the costs that would come with actually transporting and storing the oil, grain, or other commodity.
Investment products, including shares of mutual funds, are not deposits or obligations of, or guaranteed by U.S. Bank or any of its affiliates, nor are they insured by the Federal Deposit Insurance Corporation, or any other government agency. An investment in such products involves risk, including possible loss of principal. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Investments in private equity are illiquid by nature and typically represent a long-term binding commitment. The investments made by private equity funds are not readily marketable and the valuation procedures for these positions are often subjective in nature.Mutual fund investing involves risk; principal loss is possible. Investing in certain funds involves special risks, such as those related to investments in small- and mid-capitalization stocks, foreign, debt, and high-yield securities, and funds that focus their investments in a particular industry. Please refer to the fund prospectus for additional details pertaining to these risks. This information represents the opinion of U.S. Bank and is not intended to be a forecast of future events or a guarantee of future results. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are
Given the historical volatility of many commodity prices, most clients may want to limit their holdings to no more than about 10 to 12 percent of the overall value of their portfolios. Investing in commodities through futures has historically provided the greatest returns during periods of unexpected inflation. The investment managers we work with employ state-of-the-art tools that enable them to follow and act upon trends in commodity prices. Our reports on commodities and other investment vehicles, as well as our regular market update calls, provide clients with additional insight from our investment experts. ■
not guaranteed for accuracy. Investments in exchange funds are available to investors who meet “Qualified Purchaser” qualifications. While exchange funds provide diversification, they will not protect against broad market declines. Investors must remain in a fund for at least seven years before redeeming shares and those who leave prematurely may face penalties and only receive their original shares back. For additional details about various risks associated with these types of investments, investors should review the offering materials, including the Private Offering Memorandum for the exchange fund. ETN disclosure -- we haven’t used anything in the past since we don’t have these on the platform. I’ve drafted the following disclosure but you’ll need to run it by compliance for input: Exchange-traded notes (ETNs) are unsecured promises by the issuer to pay a rate of return that is tied to the change in the value of an underlying index. Not only are ETN holders exposed to market risk, they are subject to credit (counterparty) risk. Much like ETFs, ETNs can be purchased and sold throughout the trading day, however, there is no guarantee that the market price of an ETN during the trading day will reflect the change of the underlying index or commodity, thus opening the door for tracking error.
