When entering the world of commodities investing, there are many things to consider. Not only are there many different commodities to choose from, but other factors such as deciding allocations and ensuring adequate liquidity must be dealt with as well. But before beginning that process, you must first have a concrete understanding of why it is you plan to enter the world of commodities. Additionally, you should have a clear understanding of those conditions that will cause you to reverse course and exit your positions. While inflation protection is often used as a reason for investing in commodities, I see two overarching themes that drive investors’ desires to have portfolio exposure to commodities: future global supply/demand imbalances and currency debasement.
Prior to the 2008/2009 financial crisis, the story of global growth (specifically emerging markets growth) creating worldwide supply and demand imbalances in various commodities was at the helm of the commodities super-cycle. Then, as central banks and governments around the world ramped up the electronic printing presses and the deficit spending, the overarching theme seemed to change to that of protecting against currency debasement. This was especially true in oil (USO), gold (GLD, IAU), and silver (SLV).
If you are a commodities investor who supports the idea that global growth will create supply and demand imbalances in the near future, you need to be aware of the fact that in recent years, many investors who have moved money into commodities are simply there because they want to protect against currency debasement. Therefore, if you are investing in, say, oil, using traditional fundamentals as your guide, you may be overlooking the difficult to quantify premium that oil receives due to quantitative easing. If global growth does pick up one day by enough to allow the Fed to stop its unconventional monetary policy, that does not necessarily portend significantly higher oil prices. After all, there are plenty of investors who have gotten long oil to protect against currency debasement that may decide to leave commodities in favor of assets they historically invested in, such as stocks.
Likewise, if you are a silver investor attempting to protect against currency debasement by getting long the precious metal, you may be overlooking silver’s potential to sell off violently in the case of a worldwide recession. While unconventional monetary policy certainly helps the price of silver, it is very difficult to say with certainty to what degree the price of silver could ignore a global downturn.
Each commodity investor is likely to have an element of both future supply/demand imbalances and currency debasement as a part of his or her investing thesis. Before choosing the commodities in which to invest, think through the effects that each of the two dominating investment themes currently has on every commodity you are considering for investment. Moreover, think through how the future prices of those commodities may be impacted by a change in the relative importance of each of the themes.
For example, if currency debasement becomes less of a concern in the future at a time when global growth is ramping up, what will this do to the prices of various commodities? It is also necessary to think through a scenario in which currency debasement becomes less of a concern at the same time that global growth slows or stagnates. Likewise, what if global growth accelerates and central banks don’t take their foot off the gas, continuing ahead with unconventional monetary policy? Under that scenario, certain commodities will likely be more favored than others.
Before allocating any money to commodities, you should think through the types of scenarios outlined in the previous paragraph. That exercise will be helpful when deciding which commodities best fit today’s investing environment as well as when crafting your exit plan.
By. The Financial Lexicon
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