Should You Buy Commodity Funds Now?
About 15-20 years ago, China awed commodity producers by bumping up its consumption of commodities. Chinese demand shot up so much so that it started ruling the prices of many commodities in the world market, especially those of base metals. The rise of China was marked by massive infrastructure development and leapfrog jump in production capacity. Now that China is bogged down with slower economic growth, commodity prices have crashed and still not settling down or forming any base for a bounce back.
The dragon's dominance...
The commodity cycle that started in the year 2000 or thereabouts, looked mighty in 2006-07 as commodity producers and consumers both were confident. Global recession of 2008-09 pushed global commodity prices down, but they were strongly propped up by relatively unaffected demand from China and stimulus packages announced in the western economies.
As per the working paper of International Monetary Fund (IMF) on "China's Impact on World Commodity Markets" published in May 2012, China accounted for:
- Roughly 20% of global demand for Soybean;
- Nearly 50% demand for Cotton;
- More than 40% of demand for Aluminum;
- Close to 50% demand for Coal;
- 40 odd percent demand for Copper; and
- Greater than 10% of world's consumption of Crude Oil
Banking on China and perhaps grossly undermining the slowdown threats in China, global miners invested a lot in capacities; but to their nasty surprise China struggled in last 3-4 years. Today, commodity producers are finding it difficult to deal with downside pressure on prices. Their businesses are affected and their stock prices too have taken a beating.
In such a scenario many of you might be wondering if it's a right time to invest in commodity funds. Let's check out.
Blood on the street...
Although most of commodities which have wide industrial usage are in a firm grip of bears, commodity producers are not cutting production. It's clearly a race to retaining market share. For example, Brent crude oil despite being depressed prices below U.S. $50 per barrel, key producers such as Saudi Arabia are not cutting production. Similarly, even though iron ore prices have tanked, companies such as Vale SA and BHP Billiton are ramping up output to record levels. This suggests how companies are trying knock-down one another by waging a price war and adding gush of supply to already oversupplied markets. Stock prices speak a lot about these companies.
Tough time even for the mining giant
As you are aware, China has devalued its currency nearly 4% which has gone on to strengthen the U.S. dollar. So for anyone investing in stocks of mining companies listed abroad, two factors will affect the returns:
- Currency movement; and
- International commodity prices
Speaking about currency movement, in the current context fall in the value of Yuan has made the U.S. dollar stronger, while the Indian rupee has weakened.
Weak Yuan -> Strong U.S. dollar -> Weak Indian rupee
Now since many commodities are denominated in U.S. dollar, their movement has been paved by the direction of the U.S. dollar. Therefore, strong U.S. dollar has kept commodity prices weak.
Let's not forget that China has been the driving force behind many commodities and unless demand-supply situation doesn't change drastically, commodity producers may continue bleed. Hence weak demand from China, would keep commodity prices suppressed.
However, falling Indian rupee may partially insulate Indian investors. Having said this, investment in commodity funds remains risky. In 2013, when commodity prices corrected as much as 15% in first 3-4 months, some investors were tempted to invest. But performance of commodity oriented funds has turned from bad to worst since then.
Will Commodity funds recover?
Data as on August 28, 2015
Returns for the period below 1-year are expressed in absolute terms,
while those over 1-year are expressed as compounded annualized.
(Source: ACE MF, PersonalFN)
Performance of commodity funds over last 1 year has been terrifying and that over last 2-years has been bad too. This suggests that those who had bought commodity funds in 2013 are still making losses as commodity prices slipped further down.
PersonalFN is of the view that how quickly China responds to economic slump would largely decide where the commodity prices are heading. Apart from Chinese demand, if something else that can affect the movement of commodity prices, it is monetary policies of advanced nations. If Federal Reserve (Fed) in the U.S. decides to hike policy rates, in the near future, pressure on commodities will build further, resulting in even bigger impact. Although agricultural commodities have shown relative resistance, their pricing is hugely affected by domestic factors, at least in India.
On this backdrop, PersonalFN believes, you should avoid taking any exposure to commodity funds at the moment as commodities may take a long to bottom out.
PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.
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