At the start of 2021, investment in the commodities and natural resources sector looked like a no-brainer. A decade of weakness had left prices low, while a sharp economic recovery and ambitious infrastructure plans looked set to support demand. However, while some commodities have done well, investors have had to tread more carefully than they might have expected.
This has been seen in the performance of commodity and natural resource funds. Over the last six months, the top performing fund (iShares Oil and Gas Exploration and Production ETF) is up 34.2%, while the worst-performing fund is down 8% (Charteris Gold & Precious Metals). In the investment trust sector, the gap is even wider – 80.4% for the top fund and -50.9% for the worst.
Mixed performance
Oil and, particularly, gas prices have soared as economies have reopened. High demand has collided with supply problems to create an energy crunch. Energy producers have benefited significantly. Those funds positioned with high weights in these cyclical commodities have performed very well.
Elsewhere, the picture is far more mixed. There was a lot of excitement around iron ore and copper at the start of the year. Many investors believed the green infrastructure agenda would drive persistent demand for these industrial metals, particularly as President Biden passed a $2 trillion infrastructure package. However, this hasn’t happened: the Chinese government has clamped down on its debt laden property sector, which in turn has reduced demand for steel (of which iron ore is a key component). There has also been a supply glut as Brazil has brought more iron ore on stream after last year’s production problems. This has seen the iron ore price almost halve since July.
The copper price has remained steady, but without the hoped-for expansion. Around 60% of copper demand comes from wind and solar technology, electric vehicles and infrastructure and it had been hoped that the energy transition would give copper prices new momentum. This has not materialised.
The gold price has been weakening. It is generally seen as a defensive asset and therefore not a natural choice for an environment of economic recovery. It has also struggled as higher inflation has brought the prospect of higher interest rates – gold tends to thrive when real interest rates are low.
What next for commodities?
Commodities have historically had two main roles in a portfolio: as a source of portfolio diversification and to provide protection against higher inflation. At a time when equity valuations are high and bond yields low, portfolio diversification is more crucial than ever. Equally, inflation has been running at over 5% since May. Economists and fund managers are increasingly describing it as ‘sticky’ and not forecasting a drop until 2022.
Economic recovery may have lost momentum, but should still support higher demand for commodities. At the same time, ‘green’ spending should start to ramp up in the months ahead as governments take steps towards their net zero commitments. The shift to electric vehicles and battery storage should continue to boost demand for commodities such as lithium, nickel and cobalt.
The big unknown is the trajectory of China. China is still the strongest source of demand for many key commodities. For example, the country’s imports of iron ore are more than 10x their nearest equivalent (Japan). The Evergrande crisis has regulators taking a closer look at the property sector, a significant source of marginal demand for iron ore. China’s economy appears to be slowing. This may prove important for certain key commodities. Rio Tinto is a major holding in many natural resources funds, but is very exposed to the iron ore price.
Equally, the direction of gold and precious metals is difficult to call. The gold price tends to do well at times of negative real interest rates. With this in mind, high inflation and low interest rates should create a good backdrop for the gold price. However, much will depend on whether central banks choose to raise rates. Any sense that real interest rates could become less negative, either because inflation falls or interest rates rise, could dent the gold price.
Commodity prices have a lot of moving parts. These are global markets, which can be affected by everything from distribution shortages to political upheaval. Even when all the right elements appear to be in place, they can surprise investors. That said, many of the same elements are in place as they were at the start of the year and in some cases, prices are cheaper. The sector may yet reward judicious selection.
