Year of the Dog reflections: The collapse of commodities

At the beginning of every Chinese New Year, AsianInvestor makes 10 predictions about economic, political and financial developments that are likely to have an impact on the way institutional investors assign their money. And then, one year later, we revisit these forecasts to see how well we did.

Our eighth Year of the Dog forecast focused on which alternative asset class looked most likely to outperform. 

Which alternative asset class will outperform, on a risk-adjusted basis? 

Answer: Commodities – incorrect 

For the alternatives space, we argued that 2018 could be the year of the commodities. It was a bold pick. The Bloomberg Total Commodity Return Index had offered negative returns from 2011 to 2015, enjoyed very strong performance during 2016 but then offered a pickup of just 1.7% the following year.

Still, we believed that conditions in 2018 could be another time for commodities to shine. Commodity prices tend to tick upwards during strong global economic growth, and this looked the case early last year, with the US economy bolstered by a set of corporate tax cuts.

In addition, mainstream capital markets that were beginning to look a little rich, in the case of both US and emerging market equities, while offering relatively low yields in the case of bonds. Meanwhile, the amount of money chasing investments in real estate and private equity threatened (and continue to threaten) to cause asset prices to rise, and returns to fall.

It was a solid prediction. It was also very wrong.

The Bloomberg Total Commodity Return Index ended up falling 10% during 2018, from 179.49 to 161.51 during the course of the year. Not a terrific return, by any stretch.

In fairness, no alternative asset class enjoyed a particularly good year. The MSCI World Real Estate Index fell 5.56% during 2018, while the Barclay Hedge Fund Index dropped 5.17% and the S&P Listed Private Equity Index fell a whopping 18.2%. Even so, commodities were among the worst alternative asset performers. 

What our assumption failed to take into account was just how disruptive a certain US president could prove to be, or how much a stronger dollar could impact the market.

The decision by Donald Trump to embark on a series of international trade wars put a wrench in the works of many countries while causing several commodity prices to spike to such levels that demand and supply were negatively affected. His ongoing spat with China began in the first half of 2018, and it targeted the likes of steel and aluminium. In retaliation, China hit US soya beans and peanuts with retaliatory tariffs.

The result was that the prices of these commodities rose, but not because of growing demand. Indeed, the ongoing trade war has left more traders and investors fearful about global growth.

Meanwhile, the price of oil and energy commodities also slipped southwards during the second half of 2018 as the US, Russia and Saudi Arabia all raised daily production volumes. The cost of a barrel of WTI Crude fell from $60.42 a barrel on January 1, 2018, to $42.53 at the end of December.

Another drag on commodity valuations was the value of the US dollar. Commodities tend to be priced in dollars, so they become more expensive as the currency rises. And the dollar soared against many currencies during 2018, for example, increasing by up to 10% against the euro from January to November.

Added to this, the yield of the 10-year US Treasury rose to well over 3% between September until November. Higher rates make commodities more expensive to store for long periods (the 10-year Treasury yield dropped sharply in December, relieving some of this pressure).

The combination of tariffs, stronger dollar and higher rates, plus an energy supply glut and an uncertain economic outlook conspired to drag down commodity prices in 2018. They look set to continue struggling this year. 

Previous Year of the Dog outlook reflections:

Will there be any regimes changes from Southeast Asia elections? 

Will China's debt burden become a major drag on its economy? 

Will the Bank of Japan's quest to create inflation succeed?

Are European and UK stocks a good bet in 2018? 

Will the US Treasury yield curve invert?

Will Donald Trump still be president at the end of 2018?

What will be the best performing mainstream asset class, on a risk-adjusted basis?