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Portfolio diversification in physical commodities today

Johann Erasmus, executive director of 1nvest, looks at precious metals, base metals, energy and agricultural commodities, and believes these markets are ‘taking a bit of a breather’.

NERINA VISSER: There is no doubt that a lot of the turbulence we are currently experiencing in the market has its roots in China, although the threat of the Fed removing the easy-money Kool-Aid from the party is not helping to calm the September shivers. One of the current tug-of-war contests between the rising demand for commodities, driven by the Biden infrastructure plan, and the mitigation of climate-change industries and the fall in expected demand for commodities as the outlook for global growth moderates – not least in the second-largest economy in the world – has made short-term outlooks for markets even more uncertain than usual. 

This has resulted in a knock-on tug of war contest between different commodity investors – those who believe we are experiencing a healthy pull-back in a multi-year commodity supercycle, and those who are running for the exits while simultaneously trying to avoid being speared by a falling knife.

I’ve invited Johann Erasmus of Standard Bank and 1nvest to provide a more nuanced view on the commodity spectrum and to help investors who are clutching at their heaving stomachs on this violent rollercoaster. Thank you for your time, Johann. I know we don’t have nearly enough time to tackle this brave topic, but thank you for offering to join us. 

The commodity spectrum can broadly be divided into four categories: precious metals, industrials or base metals, energy, and agricultural commodities. Let’s start with the one closest to the foundations of the South African economy, being precious metals – both gold and platinum group metals (PGMs). What are the most important drivers for these commodities?

JOHANN ERASMUS: Morning, Nerina. Gold in itself still has some industrial uses, but its price is predominantly driven by external macro factors, and it is used as a hedge against uncertain risk events like we are currently experiencing, and people use it as an overall store of value. 

PGMs, on the other side – while platinum has a correlation to gold and they are precious metals – remain predominantly industrial metals, which means that the price is driven by supply and demand factors, which is the case for most commodities, barring gold.

For PGMs their industrial use or demand is predominantly in the automotive industry, in the manufacturing of catalytic converters for neutralising and cleaning the harmful gases caused by internal combustion engines. A current important factor hampering the demand side for the PGMs is the global chip shortage, wherefrom the automotive supply perspective they cannot meet the auto demand that is currently there. And then on the supply-demand we’ve seen the PGM producers all delivering a sterling set of results, meaning that they’ve been digging the PGMs out of the ground at a rapid pace while the prices were high. The combination of those two is causing the PGMs’ price to soften massively in all three of the PGM cases.

NERINA VISSER: I guess that manufacturing application of PGMs would explain also in part why they have been hit by let’s call it the contagion of this sign of the spreading economic slowdown because, when we look further afield toward industrial and base metals, China’s steel production is now at its lowest level since the global financial crisis. Iron ore prices are down 50% since their peak earlier this year. Copper prices have moved along with the ebb and flow, and are currently under a lot of pressure. Where do you see the outlook for these industrial metals in the near term?

JOHANN ERASMUS: Nerina, overall I see the commodity markets as taking a breather. The prices, as you’ve mentioned, have run very hard over the last couple of months – and then there’s this overall flow-down fear that’s currently putting a damper on the party. 

That said, I believe the global logistics constraints will still cause suppliers to hold greater stocks, driving further production going forward. 

In the longer term, I prefer commodities used in electrification and for cleaner production of energy, like your battery materials and coppers etc. So overall I think it’s a bit of a short-term slowdown.

NERINA VISSER: All right. Well, the energy, of course, the oil prices, 18 months ago were at negative levels at one stage, and oil certainly has its own supply dynamics which means it does not only follow these changes in demand. Where do you see us in the current cycle on the energy spectrum?

JOHANN ERASMUS: On the oil side we’ve seen the oil price spike. And then that’s off again, off the back of supply concerns. We’ve got Hurricane Ida in the Gulf of Mexico. There are lot of operational issues in Mexico, Russia, and Nigeria, and that is seeing the price of oil spike at this stage and run quite hard. 

I think on the longer term, oil is seen as a sunset industry.

As I mentioned a bit earlier, the world is moving to cleaner energy, but I think in the short term oil’s going nowhere. It’s there, it’s easy to extract, most of our cars run on it, as with the use of PGMs. So I think oil is still definitely here to stay for a while.

NERINA VISSER: Okay. And then finally, agricultural produce. It is probably most affected by the weather which is a significant driver of food inflation specifically. In a world concerned with rising inflation, or not, depending on how transitory the drivers of inflation prove to be, what is the outlook for agricultural commodity prices? 

JOHANN ERASMUS: I think the inflation is going to drive those prices for a while. As we mentioned, there are the supply constraints, the input costs are rising massively for the farmers, and so on. So I think overall there are still some legs in the commodity prices. 

As you rightfully said, there are weather concerns. We carry quite dispersing weathers and it’s becoming harder and harder to judge what’s going to happen around the droughts and the floods. So [given] that, combined with our increasing population and the inflation fears, I think there’s going to be some price growth there, definitely…

NERINA VISSER: Johann, thank you for reminding us that commodities really come on quite a broad spectrum. For investors wanting to get exposure to different components of the commodity spectrum, you do have a range of exchange-traded products that provide investors with exposure to (commodities).

So it’s certainly useful to remember that an investment in physical commodities acts as a good source of diversification in a portfolio and that the standalone risk of these sometimes violent price movements should not be viewed in isolation. 

Johann, as Simon would say, I appreciate the early morning. 

Listen to Tuesday’s full MoneywebNOW podcast here.

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