Graham Macdonald, MBE
MBMG International Ltd.
Nominated for the Lorenzo Natali Prize
Are Commodities an asset class?
Global investment in commodity-based exchange-traded products,
structured notes and index swaps totalled approximately USD100 billion
in 2006. Six years later, this number had risen to a record high of
USD415bn. This is largely explained by the fact that commodities are now
standard components of strategic asset allocation as they generate
equity-like returns in the long run, act as risk-diversifiers, and serve
as an inflation-hedge.
However, given the practical, regulatory and ethical difficulties of
investing in physical commodities, the challenge of choosing from a
bewildering multitude of index products, and the recurring bull and bear
markets in commodities, "the decision to invest in a diversified
commodity hedge fund manager seems almost a no-brainer" (Source:
Barclays Capital - Hedge Fund Pulse, September 2011).
Until, that is, you consider the challenge of finding a
well-diversified, discretionary commodity hedge fund manager with a good
track record that is open to new capital. Very few commodity hedge funds
are generalists; most choose instead to focus narrowly on a single
commodity type such as agriculture, energy or metals. This is because
many commodity specialists, who started out as prop traders at
commodities houses, have considerable expertise in fundamental analysis
and market information flow (i.e. who was moving which commodities in
what volumes and in what locations) of specific commodities. These
managers typically make sizeable bets focused on one area or on a single
This latter approach did well in the years leading up to the financial
crisis of 2008 but has become less effective as the commodity markets
have become increasingly driven by factors other than supply and demand.
As central bank interventions and investor sentiment have become the
major price determinants, this 'financialisation' of commodities
post-2008 has led to greater price volatility and intermittently greater
correlation with other risk assets. These flow and fundamental-based
traders have struggled to capture meaningful returns as they frequently
lack the awareness of the macro-economic analysis that is required to
manage risk and reward in the current environment.
The Newedge Commodity Trading Index is -2.59% for 2012 as of December
and, for some, the changed trading environment has proved decisive. Some
highly successful funds, e.g. BlueGold with peak assets of over
$2billion, have closed and returned money to their investors. In this
environment, where government policy distorts the expression of
fundamentals, those flow and fundamental managers who have remained too
true to their fundamental supply and demand analysis have been run over
either by the wall of liquidity provided by central banks, or by waves
of risk aversion triggered by geo-political events.
In reality, this increasing commodity volatility has not occurred in
isolation. Commodities have been undergoing a decade-long period of
increasing volatility spurred by global, broad-based demand from
emerging markets and tightening global inventories. These tightening
supply/demand conditions exacerbate commodity volatility, but will
probably lead to higher returns over the long term. However, the other
way to do it is to use a fund manager who integrates macro-economic
factors in its investment process but, as implied earlier, the
volatility is a lot higher within the commodity asset class.
Why it is sensible to fall off the cliff
Recently, my business partner, Paul Gambles, appeared on CNBC’s Asia Squawk
Box when he was on a trip to Singapore. At MBMG Asset Management, we have
been talking about the Fiscal Cliff for some time now. This is where the
combination of automatic spending hikes and tax cuts expiries that will
happen at the start of the year unless US politicians finally rediscover the
ability to compromise. The negative impact on GDP could be around 2%,
sending the US and, mostly likely, the world into another recession - though
many in Europe might protest that they have not yet come through the first
If you switch on any American news network, of which we are blessed (or
cursed) to have access to many here in Thailand, you will be positively
bombarded by US politicians on both sides of the house stressing the grave
nature of the situation, the importance of avoiding the fiscal cliff, and
then making a lot of white noise on compromise whilst offering few
suggestions of what they would actually be prepared to budge on. However,
the intransigence of the election season is slowly wearing off. The most
likely outcome is a fudge, the debt ceiling will be pushed higher and
sequestration (the automatic cuts and hikes) will be avoided.
The above economic summary is great but as with
all US or European issues at present, we do not need degrees in economics,
we need political degrees to establish odds. What makes economic sense may
not be how the voters cause political leaders to behave. Everyone is
assuming or convinced the Washington politicians will not cause a US
recession, the very same bunch just spent US$6bn re-electing someone into
the same job.
So now that everyone has decided to start panicking, why have I stopped
worrying and learned to love the Fiscal Cliff? Why did Paul Gambles say on
CNBC that, likely a slightly beardier and more wonkish Thelma and Louise,
Geithner and Bernanke should stop worrying too, and drive the American
economy over the Fiscal Cliff with as much gusto and conviction as Thelma
when she stepped on the accelerator of the 1966 Ford Thunderbird?
It is quite simple really. The US Congressional Budget Office’s Long-Term
Budget Scenario projections for debt illustrate it clearly. The Thelma and
Louise scenario, where the initial pain of the recession is endured, puts
the US national debt back on a sustainable path to steadily decrease to
around 50% of GDP by 2040. This is represented in graph 1 by the Extended
Baseline Scenario. The fudge option, sends US publically held debt (which is
currently around 72% of GDP) spiraling off the map towards 200% of GDP by
These projections look scary, and they are far enough in the future that the
hope this can be avoided is still firmly within our minds. But you only have
to look at Japan to see the future today.
In the UK, the Bank of England changed its governor a few weeks ago. There
was surprise when it was, shock-horror, given to a Canadian. A foreigner
leading the Old Lady of Threadneedle Street for the first time in its
history! Perhaps it is also time for a change at the top of the Federal
Reserve. Let’s face it they could not do any worse than the recent
Some are complaining about the cost of bringing in this chap. However, let’s
look at this in perspective. The US electoral marathon is thought to have
cost a combined USD6 billion. By contrast, the Chinese elected their new
leader this week for about 0.001% of that astronomical figure. But the
selection of China’s new leader is arguably even more important than the US
media showpiece that has overshadowed it. Of which there is no doubt, the
leader of the not-so free-world will not be tweeting his devotion for his
folk singer wife, or taking anything else viral online.
The Chinese leadership transfer from Hu Jintao to Xi Jinping faces different
“fiscal cliff” issues to the US. The former being a ten year planning debate
over moving to a consumer driven and internally focused economy, with
significant balance sheet strength. The latter being one of what needs to be
done to improve the diabolical balance sheet, with serious politically
wrangling in the short term.
Standard Life, an Edinburgh based asset manager wrote a very good summary of
the economic issues, or the “fiscal cliff”, faced by the US economy. Based
on the Congressional Office estimates they concluded (emphasis in brackets):
* The impact of even the full fiscal cliff has been exaggerated. (For a full
4% to be shaved off GDP next year, then the full tax increases need to be
enacted and the full spending cuts need to be implemented.)
* A positive monetary policy tailwind (i.e. QE Infinity) will at least
partially offset the fiscal headwinds.
* An expected pick-up in private sector borrowing will partially offset the
public sector contrarian.
* The fiscal cliff will be cut down to size with a GDP hit of 1.0-1.5% a
year, rather than max 4.0%.
* A meaningful deficit reduction program will be established.
* The US economy will not be derailed (because everyone is too scared to
cause a recession, which is what is actually required).
The above data and
research was compiled from sources believed to be reliable.
However, neither MBMG International Ltd nor its officers can
accept any liability for any errors or omissions in the above
article nor bear any responsibility for any losses achieved as a
result of any actions taken or not taken as a consequence of
reading the above article. For more information please contact
Graham Macdonald on [email protected]