So much for the commodities supercycle.
Commodities have provided “underwhelming returns” over the past 25 years, and are not quite the hedge against inflation that some investors believe, Morgan Stanley said, taking issue with a famous academic paper on the asset class.
But that does not make the asset class a lost cause for investors, the bank said, flagging the potential for “healthy real returns” from being more picky in commodity bets.
Betting on the top main commodity indices, the S&P GSCI and the Bcom, has offered total returns of about 2-3% since 1991, well below the 6% offered by 10-year US Treasury bonds, and the 11% offered by shares as measured by the S&P 500, Morgan Stanley said.
Returns “have been disappointing on average versus other popular assets”, the bank said, contrasting with the increased popularity of commodities among investors, and work by academics such as Yale University’s Gary Gorton and Geert Rouwenhorst supporting the asset class.
While acknowledging that the work by the Yale academics showed returns from commodities in line with those of shares, and well ahead of those of bonds, such work was based on a strategy of spreading investment equally between 36 commodities – easier in theory than practice.
“This index is not practically investable and appears to include commodities that have shallow liquidity – butter, milk and oats each had the same weightings as gold and crude oil,” Morgan Stanley said.
“The major investable cross-commodity indices are far from equal weighted and are largely based on global production values and liquidity.”
However, following strategies such as momentum - which sees investors bet long on commodities with rising prices, and short on those for which values are falling – or “carry”, which focuses on futures in which distant contracts are lower prices than near-term ones, “provide healthy real returns”.
“Since 1992, momentum portfolios in particular have offered risk-adjusted returns over and above inflation that are much higher than some of the best-performing commodities,” the bank said, highlighting that the asset class appears particularly well suited for such a strategy.
“Momentum works because commodity prices can be sticky, with persistent overshoots in either direction,” with supply shortages, or gluts, potentially taking some time to rectify.
As for carry - in which investors exploit “backwardation”, investing in a distant contract in the hope that it will rise in value as it approaches expiry - Morgan Stanley cited gasoline as a candidate, with its futures curve tending to show the right shape “during summer months, when travel demand rises.
“Corn forward curves also display backwardation in months just before the harvest when supply is most depleted.”
The bank also flagged the potential for a return of inflation to boost commodity returns, “given their nature as a real asset and contribution to CPI”, or commodity price inflation data.
“Very low inflation is a symptom of a low growth environment where commodity demand cools.”
However, there was a limit to the capabilities of commodities as inflation hedges, with the asset class also underperforming in periods of high inflation, which “may result in demand destruction that impacts returns”.
The bank flagged a “sweet spot” of inflation between 3-5% when “real returns are highest”.
Unfortunately for commodity investors, Morgan Stanley sees US commodity price inflation remaining at or below 2% until at least the end of next year.