Fly High With Commodities

With equities showing no signs of a rebound, investors can turn their attention to commodities, albeit with caution.

 While equity markets globally have not yielded impressive returns in recent times, commodities have more than made up for it. The Sensex has fallen 7% since the beginning of the year while the MCX Comdex, India's Composite Commodity Index, has risen 25% during the same period. In an environment marked by rising inflation, high interest rates, declining industrial production, governance issues and political turmoil, prospects of equities rebounding in the near term appear rather weak. Commodities, on the other hand, have had a splendid run since June last year. Base metals have risen almost 50%; gold was up 16% while silver rose 90%. Yet, the market is still bullish on commodities as an asset class.
    In the second half of 2010, asset classes across the board provided investors moderate returns, making up for the sluggish beginning at the start of the year. This rally was triggered by nascent signs of economic recovery in the US and Europe, and more importantly, by the US Federal Reserve's second stimulus package — Quantitative Easing (QE2). This additional liquidity triggered a spurt in equities, especially in emerging markets like India, reflecting in returns of 17% on the Sensex from June to February 2011. Interestingly, the MCX Comdex rose 30% during the same period outperforming the equity markets — a trend witnessed across the globe. The S&P 500 gained 11% while the S&P Global Commodities Index rose 14% in 2010.
    A key driver for global investors to flock to commodities was the printing of money in the US that saw the dollar lose value against several currencies, coupled with low interest rates in the West. Therefore, relative to other asset classes, commodities proved to be the safest bet, spurring investment. Second, this excess liquidity also led to high inflation, especially in emerging economies — further pushing up commodity prices.
    Strong demand from China and other emerging markets, coupled with supply constraints in Russia and South America on account of climatic adversities, added further impetus to the upward price movement. Commodities across the spectrum fared well. From the agricultural sector, cotton was the star performer, gaining 80%. Silver was the best performer among precious metals, mainly driven by its increasing inclusion in ETFs.
    Whether this trend in commodities will continue hinges on how geo-political issues pan out. The Middle East, North Africa tension has seen base metals correct from their February highs. The Japanese calamity has doused the rally in most commodities in view of the slowdown in demand. A further correction could be expected, but the medium-to-long-term outlook is positive. This is supported by the case for redevelopment in Japan after recent events.
For A Safe Landing
While commodities as an asset class offers good opportunity of making money, it also involves certain inherent risks. Investors need to be aware of them before they start trading
    In India, commodities exchanges provide only futures contracts for trading. Options, a safer alternative, is not currently on offer
    It is pertinent to understand the fundamentals of a commodity, just the way one studies the fundamentals of a company before investing in it
    Investors are subject to high leverage in commodity futures trading. Hence, one must always beware of overleveraging one's portfolio and not trade a contract that is considerably larger than one's risk appetite
    Price action in commodities can become very volatile, thanks to a variety of factors such as geo-political crisis, weather changes and calamities. Investors, therefore, need to be agile while trading.
    The philosophy of 'adhering to a stop loss' needs to be followed even more diligently while trading commodities ET Intelligence Group analyses trends in the most actively-traded commodities to help you cash in on investment opportunities.

In 2010, aluminium prices rose 8% y-o-y fuelled by the recovery in the US and Europe in the second half of the year. Compared with other base metals such as copper, tin and nickel, the rise was muted. The outlook for aluminium is positive as demand remains robust on back of growth in the packaging industry in India, China and Latin America and recovery in the transatlantic markets. However, large inventories are likely to keep prices range-bound in the near term.

Copper prices increased 31% y-o-y on the back of supply constraints, which are expected to continue through 2011, signalling further buoyancy in prices. It has corrected a little from record highs in early February. However, lower inventories and robust demand from India and China will restrict any drastic fall. The outlook on this base metal remains positive.

Corn prices have gone up 80% in the past one year. They are likely to correct in the short term, partly on account of a temporary decline in Japanese demand (Japan being the largest importer) and bearishness ahead of the South American harvest. The outlook is bullish in the medium term as Japanese demand has been delayed and not doused. However, investors cannot expect returns of the same magnitude as last year since the South American harvest is likely to be good this year.

Cotton has been the best performing commodity - yielding returns of more than 145% in last one year. There is an expectation of reduction in demand with prices remaining near all-time high levels. The global cotton production may outpace demand for the first time in seven years. However, the expanding Chinese imports may support demand for cotton. Prices of cotton are therefore likely to remain volatile given such demand-supply dynamics. In India, cotton is competing with food items for acreage. Since prices of food items have risen exponentially they are getting more acreage than cotton. So, while the demand for cotton is optimistic on back of rising consumption, the prices are likely to remain volatile as production is going to be uneven.

The demand-led uptrend in global crude oil prices since December 2010 was further accentuated in January onwards due to the political upheaval in Egypt and Libya. However, the rally was largely psychological rather than fundamental. The global oil inventories have remained higher than the 5-year average and spare production capacity with OPEC has been comfortable. As the political unrest spread across Bahrain and UN prepared to enter Libya the oil prices continue to remain high. However, the disaster in Japan and approaching low-demand June quarter are putting pressure on oil prices. Further, the International Energy Agency noted that high oil prices are dampening demand and lowered its 2011 demand estimate. Unless the geo-political tensions continue, oil prices are likely to drift lower in near term

Gold continues its unprecedented rise in 2010, gaining 30% over the previous year. On account of uncertainty of the global economic recovery and the euro zone debt crisis in the first half of the year, investors rushed to safe havens such as gold. Though these issues have subsided, gold as an asset class is still likely to yield positive returns as uncertainty regarding the pace of economic recovery in Europe and the US continues. In the near term, there could be a correction as the Japanese central bank is likely to continue selling the precious metal to inject yen into money markets in an effort to calm investors.

Silver has had a stellar year in 2010, outperforming gold and yielding returns over 80% against the previous year, driven by investment demand. In 2010, silver holdings in ishares ETFs rose 15% touching an all-time high. It would be prudent to book profits in silver at this point and wait for a correction. Given that the rise in silver is also linked to industrial metals, any correction in the latter could cause a dip in silver price.

Soybean oil futures prices have risen over 42% in the past one year. However, they have been trading sideways for the past three months. They are likely to remain weak in the short term due to advance in harvesting activities in South America, expectations of a higher supply of soybeans this year and present weakness in crude oil prices. Prices are also likely to weaken around May-June period on the back of fresh production of palm oil from Malaysia. However, they are likely to rebound later in the year. Edible oil prices are closely linked to energy prices due to their use in the production of biodiesel, an alternative to fuel. Hence, any major spike or correction in crude oil prices will have a similar impact on soy oil prices.

Global sugar prices touched an all-time high in February due to the Australian cyclone and remained volatile since then. According to the latest analyst estimates, raw sugar future prices are expected to see a correction due to better production in Brazil in May 2011. In the domestic market, sugar prices are expected to trade in the range of 28-30 per kg in the short term. They are likely to correct in the case of any upward revision in the sugar production estimates which currently stand at 25 million tonnes for the current sugar year (October 2010-September 2011) against the consumption of 22 million tonnes.

Among all the base metals, zinc was the only underperformer in the past year, yielding negative returns. This was primarily because for the fourth consecutive year, global output of refined zinc exceeded its usage. While the surplus is expected to be lower in 2011, its impact is not likely to see any major improvement in prices. So, while the rise in the price of zinc is on the cards, it may not be very significant.
    crystal.barretto@timesgroup.com 
    (with inputs from Rajesh Naidu, Ramkrishna Kashelkar and Shikha Sharma)

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