Morningstar on Commodities
Our house view puts valuation at the forefront.
This article originally appeared in the Winter 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.
Amid trade wars and a global growth slowdown, investors have fled to gold so far in 2019. Meanwhile, many commodities are struggling. But these asset classes perhaps shouldn’t be viewed as either a safe haven or a bet on macroeconomic trends. Low correlation with other parts of a diversified portfolio is one reason to invest in these areas. Valuation may be another—for long-term investors who can ride out risks. Brian Huckstep, a portfolio manager and multi-asset specialist with Morningstar Investment Management, and Kristoffer Inton and Jeffrey Stafford, both directors of equity research with Morningstar Research Services, joined me to share their insights on allocation strategies and investment opportunities. Our conversation took place on Aug. 29 and has been edited for length and clarity.
Christine Benz: Let’s start with a definition. In my mind, commodities are raw materials or agricultural products that come from the into something, or collected. How would you define it?
Brian Huckstep: In Morningstar Investment Management, when we build portfolios we think in terms of asset classes, which include investments that exhibit similar characteristics. The investments you mentioned do; they exhibit attractively low correlations with equities and bonds. When we think holistically about portfolio construction, we also consider cash. Cash is a little bit like commodities in that it’s got lower returns but low correlation with other parts of the portfolio.
Kristoffer Inton: It’s not just raw materials that come out of the ground, but also includes goods like steel and some more basic chemicals. Commodities can require some processing but share a common feature in that they exhibit very little differentiation.
Benz: Do you tuck precious metals under the same umbrella?
Inton: Precious metals warrant a separate categorization. With agricultural commodities or even industrial commodities—whether you use copper to build wire for a house or corn to feed livestock—it’s gone once you use it. The supply and demand dynamics are about what is going to get produced in the future. Precious metals are considered precious because today’s demand is also tomorrow’s supply. The amount of gold that exists today will exist forever, plus whatever we mine going forward.
Benz: How does cannabis fit in here?
Inton: The challenge is that cannabis is so new and different than anything that exists today. Some primarily consider it a medicine, while others are categorizing it with alcohol and tobacco. To us, for right now, it is more commodity-like in nature. It’s a crop, and there’s not a significant amount of differentiation in the product. But we will see more differentiation in the future, especially as more consumer products are developed.
Benz: You could try to invest in these products straight up, but you’d have to store and insure them, which is not practical. You could invest in companies that are involved in the production of commodities. Or you could buy a derivative product that tracks commodities. Are there any other ways that one might approach these groups?
Inton: There are also ETFs that invest directly in gold—SPDR Gold Shares GLD is the most popular one. The volume and storage requirements for ETFs are a lot less than for other investment methods.
Jeffrey Stafford: Something I’d add about investing via individual companies: When you’re investing in a public equity of a commodity producer or extractor, you’re likely to get a leveraged return to the commodity price because of operating costs and financial leverage. All else equal, if the commodity price goes up 10% and you have a producer that has fixed costs and financial leverage, you should expect the enterprise value and the stock price of that business to go up by more than 10%.
Inton: While equities offer leverage to commodity prices, you’re also taking on company-specific risk. When you’re holding a commodity itself, you’re exposed only to the macroeconomic factors behind it. With equity exposure, you take on risks such as a mine collapsing or labor challenges, which leads to a high or very high uncertainty rating for almost all of the miners we cover. For example, South Africa has been a very challenging place to operate. It hasn’t had the best safety record, and there has been a lot of labor unrest. In places like the U.S. and Canada, labor is more expensive but there’s much more stability and predictability. People prefer to mine in those countries, and that’s reflected in more premium valuations.
Opportunities and Trade-Offs
Benz: Does that create opportunities for active investors, as stocks can get mispriced more readily than commodities?
Inton: Definitely, especially in an environment where maybe the commodity price isn’t moving or may even fall. If you’re investing with a company, there are operational levers that may be able to generate return nonetheless.
Huckstep: We’ve regressed the historical returns of the equity of firms that work in commodities markets against both commodity returns and broad stock market returns. We’ve found that these companies tend to exhibit a high correlation with commodity returns and a lesser correlation with stock market returns. They’re not a perfect hedge, they’re not as good as a physical commodity in that sense, but they’re still pretty good. We sometimes have more positive return expectations for those types of investments, and you still get some of the correlation benefit.
Benz: That leads to the role of commodities in portfolios. What do they add to the risk/return profile?
Huckstep: There has been a significant change to the commodities markets. Between 1970 and 2007, liquid commodity investments produced double-digit returns. Since 2008, returns have been negative. Our group forecasts long-term returns for commodities, and prior to 2008, we saw positive collateral returns, positive roll yield, and positive spot price impact. Those are three components of returns of liquid commodities.
The price of gold is what the market will bear. The price of gold was above $1,900 a decade ago, and now it’s below $1,500, so you lost 25%. But liquid commodities are a little bit different. Futures have exposure to three different components. The spot price is easy to understand. If prices go up for the physical commodity, you typically have a positive return. But the two other components are important. If you invest in a liquid commodities fund, the portfolio manager typically invests it in a collateral, usually a Treasury bond. So, you also suffer duration risk.
Roll yield is the third component. In futures markets, you make a deal to buy a commodity in the future, and that price for that commodity can either be higher or lower than what it is today. Before 2008, the majority of commodities futures had positive roll yield. Now, roll yield is negative for most liquid commodity investments, and it’s prudent to consider that. When we talk about what to expect from commodities going forward and what they add to the portfolio, one of the most important things to consider is the expected return. And today, our group is still forecasting lackluster expected returns.
Of course, you get the benefit of lower correlations with stocks and bonds. It’s like buying fire insurance on your home. Your home may never burn down, but was it the wrong decision to buy that insurance? That’s why we see some multi-asset portfolio managers allocating a little bit to commodities, even with the expectation that returns may be subpar.
Benz: Jeff, increasingly, investors get their exposure to energy stocks by simply buying a total market index fund. Is that a legitimate way to obtain exposure to the sector or should it be considered separately?
Stafford: I do think that’s a legitimate way to get exposure to the energy sector. But energy as a percentage of the S&P 500 is down to around 5% today, whereas 10 years ago it was close to 15%. A lot of that has to do with oil prices. Most of that share comes from the large, major oil producers and refiners, such as Exxon Mobil XOM and Chevron CVX. They’re integrated players so are fairly representative of the energy space.
You get the upstream business, which is the exploration and production of oil and gas, and the downstream business, the refining and retail distribution at, say, a Mobil gas station. But you’re not getting everything. The midstream space—the transportation of oil and gas once they come out of the ground—is probably a bit underrepresented if you’re just buying an S&P 500 index fund. And the pipeline business is really commodity-insensitive. Commodity price fluctuation generally has no direct bearing on the cash flows of those midstream companies, so that’s an area of the energy space where people who maybe don’t want commodity exposure are looking to invest.
Huckstep: We are overweight master limited partnerships in many of our portfolios, based on attractive valuations. We’re trying to minimize energy price exposure, and these are midstream businesses focusing on energy infrastructure. Stafford: We think the midstream space looks cheap, and it’s a way to include energy in your portfolio without having to worry that much about the price of oil and gas.
On a relative basis, from the industry level, we look at aggregate price/fair value ratios, and the services names are also cheap right now. We really like Schlumberger SLB. It is a leading oilservices company with operations around the globe, and we think the market is undervaluing the stock by nearly 50%. Essentially, Schlumberger’s revenue is the capital spending of oil and gas exploration and production companies; they assist and service the E&P companies in the extraction process. We think the market has an overly pessimistic view of international oil and gas capital expenditures.
For more holistic exposure to the upstream and downstream, I’d point out Total TOT. It’s an oil and gas giant that explores for and produces hydrocarbons, but it also has significant refining operations. Total continues to present a compelling opportunity, even after it’s outperformed its peers in recent years. We expect production growth paired with cost improvements to drive its value over the next several years.
Benz: Jeff and Kris, how do you factor in macroeconomics in order to value these companies?
Inton: Before we even begin looking at the companies, we look at the commodity itself, and that starts with looking at the supply and demand picture. The factors that drive gold or oil or fertilizer are very different.
Stafford: Oil is a commodity where demand has tracked fairly closely with the broad-based GDP number. But with copper you might not want to consider a total GDP number because it’s more aligned with fixed asset investment. If you’re looking at an agricultural product, you’d probably be more concerned with the consumption aspects of GDP.
Benz: How has slowing growth in China influenced your inputs?
Inton: China has been a big driver of why we’ve been relatively bearish on a lot of industrial commodities over the last several years. China built in 10 to 20 years what took the U.S. 100 years to build. That led to a huge amount of demand for things like copper and iron ore, and those commodity prices took off. During such times, miners flush with cash facing very strong demand often start opening new mines, increasing supply. But as China completed its rapid build-out, it’s been attempting to switch from an investment-led economy to a consumption-led economy, driving demand for many industrial commodities sharply lower.
Benz: Jeff, how have concerns about global economic weakness shaped your view of the energy sector?
Stafford: We don’t try to forecast near-term moves, but you need to have a view of what’s going to happen over the next several years in order to forecast demand. We expect oil demand to increase annually at roughly the same pace as it has for the last few years, averaged over a several-year period, but with a slight decline based on slowing demand growth in developed markets.
Benz: I once heard a fund manager say that a bet on oil stocks is akin to a bet against human ingenuity. How do you and the team factor in climate change considerations? And are there any alternative energy companies you like?
Stafford: It’s not that we incorporate climate change explicitly into the research; it’s about how we expect the demand for oil to change in the long term, based on how technology is changing. And we do expect big changes. Kris’ team puts out an electric vehicle forecast for the next 10 or 20 years, and they’re bullish on EV adoption. That has very negative implications for gasoline demand. We expect much lower consumption of gasoline in the U.S. than we have today as EV demand ramps up. It’s important to note that we’re still a long way from the point that there will be so many EVs on the road globally that oil demand will take a big hit. But if you look out to 2040, 2050, there are severe implications for oil demand.
Most of the stocks we cover in the alternative energy space look expensive right now. But there are two names that might look compelling in a pullback: NextEra Energy NEE and First Solar FSLR. Both are more than fully valued right now but may present buying opportunities in the future. NextEra is a regulated utility with a strong pipeline of renewable energy projects. It is already the largest wind producer in the U.S., and it’s a best-in-class operator in the alternative energy space. First Solar is a designer and manufacturer of solar modules and is well positioned to benefit from an increase in solar energy that we’re likely to see globally as costs continue to fall.
Benz: What about the big energy producers?
Stafford: Some of the bigger names, especially the European names like Total and BP BP, are positioning their businesses to survive as oil and gas become a smaller portion of the energy stack. But it’s like turning a cruise liner around in the middle of the ocean. They’re still going to have a lot of exposure to oil and gas.
Benz: Kris, one of the biggest drivers of gold prices is jewelry demand. How do you analyze that?
Inton: We focus our work on India and China, as these two markets dominate global demand. Gold holds particular significance there, as it’s often a gift at weddings and religious and cultural festivals. Our expectation is that, as incomes continue to rise in these countries, consumers will spend more on gold, though probably at a decreasing pace. But there are other factors that come into play. Exclusivity and luxury are part of the appeal of gold jewelry. When more people have gold, it’s potentially less attractive. In China, over the past few years, traditional gold jewelry has been falling out of favor. Jewelers have had to offer more unique products to keep demand going.
Benz: Do you see more upside for gold ahead?
Inton: In the short run, gold is dominated by investment demand, making it harder to predict. In the long run, we don’t think there’s a lot of upside to go. What has driven the gold price recently is the Federal Reserve. Because the Fed is cutting rates right now, it’s increased the attractiveness of gold.
When you look at gold as an investment, you have to consider the prevailing interest rate on Treasuries and inflation. U.S. Treasuries and gold are considered two of the best safe-haven investments. Gold doesn’t pay interest, but it tends to increase in value with inflation. In contrast, Treasuries pay interest, but that rate doesn’t change for inflation. If inflation is higher than the interest rate, you want to own gold.
On top of that, we’ve arguably entered a period of higher geopolitical uncertainty than we’ve had in the last several years. That fear dynamic feeds into that safe-haven aspect of gold, and so it’s led to a very rapid rise. We were at roughly $1,250 an ounce at the start of the year and are at roughly $1,500 today. But in the long run, we don’t think that, in a normal midcycle environment, the U.S. would cut rates enough and inflation would be high enough to keep that investment demand going. We anchor our outlook on jewelry, and we think gold prices should be closer to $1,300 an ounce.
Putting It Together
Benz: Brian, if you’re putting together a target-date allocation for someone retiring in, say, 2055, how would you approach these asset classes?
Huckstep: As 2055 is a long way away, those investors don’t need the same kind of inflation protection that investors in or near retirement do. Equities tend to provide a very reasonable hedge against inflation in the long run. Firms can typically increase prices as costs go up, so earnings are not necessarily affected too much by inflation. However, if you’re in retirement and we get a spike in inflation, your spending ability is immediately cut. You don’t have time to wait for equities to catch up, and you typically don’t have as much in equities in your portfolio. In that case, commodities and highly inflationsensitive investments are much more important.
Benz: What would you use other than Treasury Inflation-Protected Securities?
Huckstep: TIPS are a great hedge against inflation, but not many people realize that floating-rate notes are also a good hedge. Floaters typically have been pegged to Libor, though we’re seeing them start to be pegged to other things, and Libor tends to be sensitive to inflation. If inflation were to hit 7% to 10%, we’d expect to see coupons go up pretty quickly for those floating-rate securities.
We diversify our portfolios and spread the allocations around. TIPS bring on their own unique interest-rate sensitivity. REITs are another good inflation-sensitive asset class, but they have their own risks. We are also valuation-sensitive. In our portfolios today, there isn’t as much commodity exposure. REITs look pretty expensive to us, so there isn’t as much REIT exposure, either. Meanwhile, we have a little more in TIPS.
Benz: So, commodities overall are too expensive currently?
Huckstep: The spot price for a lot of commodities is not expensive: Gold is still down 25% from its peak in 2011, as an example. Many commodities are still underwater for prices, so when we look at the spot price, we may be bullish on a particular investment, based on valuations. However, we think that the negative roll yield for liquid commodity investments is likely to be detrimental to future returns. That hits a lot of things, like coffee and soybeans.
If somebody is concerned about inflation, there’s nothing wrong with adding physical securities, like SPDR Gold Shares. We expect returns to be low; we’re not putting those in our portfolios today. Typically, over the long run, physicals return around inflation, about the same as cash. There’s nothing wrong with cash in portfolios, either.
Some people wonder if active management it is not a silver bullet. I took a look in Morningstar Direct, and there are nine ETFs offering raw and liquid commodity exposure and seven active mutual funds that have been in existence over the past 11 years. The Diversified Bloomberg Commodity Index is down 64% over that period, and I hoped to find active managers that have done better. But returns among the ETFs and active managers are surprisingly similar, after accounting for fees. That roll yield is still having an impact on both active and passive funds.
Benz: You’ve looked at investor returns, or dollarweighted returns, in commodity products. How have investors done?
Huckstep: Over the past 11 years, not so great. Commodities peaked right around the time the S&P cut the rating for U.S. government debt. Kris’ comments about the link between Treasuries and gold are right on. When S&P came out with their ratings drop, gold spiked up in price. And broad commodity liquid indexes are down 64% since then.
Benz: And that’s when most investors bought them, right?
Huckstep: Yes, 2008 stoked fuel on the fire. There was a lot of demand. Companies had been building a supply of these products, so they were becoming popular. In the early 2000s, we started seeing mutual fund companies want to present the benefits of liquid commodity investing to us. When the financial crisis happened, gold and commodities in general became that much more attractive. Benz: But they didn’t earn their keep during the financial crisis.
Huckstep: When demand just gets too hot, prices typically will come back down. People were bidding the prices of the futures to such an unattractive level, they did what we predicted they would. Even today, as evidenced by negative roll yield, liquid commodity investments may still be so popular that the investor returns are still going to be poor going forward.