Commodities have been a large contributor of wealth for our nation – our economic fate as it stands, is intrinsically tied to the fate of this sector.
Aided by Morningstar equity research analyst Jon Mills, this article looks at the ins-and-outs of a commodities – a big contributor to portfolio performance for many of us, through resource shares.
Let’s start with what is meant when we reference “commodity prices”. The main commodities are iron ore, coal (thermal and metallurgical), copper, and oil.
Commodities have been in the news recently - prices are up sharply in response to the global acceleration of economic growth accompanying the COVID-19 economic rebound.
Russia’s invasion of Ukraine has further driven commodity prices higher as Russia is a major exporter of nickel, aluminium, oil, thermal coal and palladium.
Diving a little deeper, there is a cyclicality in the demand for commodities as economic growth drives consumption and in turn, prices. This feeds cyclicality on the supply side as high prices drive exploration and increased production.
While demand is mainly driven by changes in economic growth, there are structural factors that also impact demand. One such factor is the massive increase in steel production in China over the past two decades as it has invested in real estate and infrastructure, which has dramatically increased the demand for iron ore.
Commodities also face a few structural tailwinds that impact demand, such as decarbonisation and electrification – increasing demand for copper, nickel, aluminium and lithium as the world attempts to get to net zero carbon emissions through renewables and electric vehicles.
Exacerbating the current dynamic is the fact that many commodities have seen limited investment in new supply since the bottom of the last commodities downturn in 2015-2016.
When thinking about supply, remember that commodities are a depleting resource – the only way to replenish reserves and continue business is by finding new deposits.
Oil and thermal coal are the poster children for this phenomenon. In the case of oil, we’ve also seen large-scale reductions of the inventories that built up during the pandemic and as a result of the brief price war between Russia and Saudi Arabia.
A contributing factor is low oil prices since 2014 - that has meant that supply hasn’t been able to keep up with the increase in demand since the pandemic.
Supply issues plague thermal coal as well, attributed to some banks refusing to finance new coal mines. Capital allocation decisions have also contributed to the lack of new supply - we saw rapid expansion of iron ore companies back in the late 2000s to the early 2010s. The widespread anger from shareholders at the time has led to a preference by large mining companies for returning cash to shareholders via dividends, in our view.
In the near term, Morningstar sees the likes of iron ore, copper, metallurgical and thermal coal prices staying elevated due to the increase in economic growth from COVID-induced lows and supply issues.
However, commodities are cyclical, and we think capitalism will ultimately do what it always does. New supply will come, or substitutes will be found to reduce demand. We expect commodity prices will return to our mid-cycle estimates in around 2025-26.
So, how should investors incorporate commodities into their portfolio, if at all? Chances are that as an Aussie investor, you are exposed to commodities in a meaningful way already.
As investors, Aussies have a strong home bias. Many of us have majority or exclusively Aussie equity portfolios. This means that the domestic equities make up a disproportionate part of our portfolio, and in turn, so do commodities.
How much commodities exposure is ideal? At Morningstar, we believe that portfolios should be goals-based – meaning, focus on a financial goal instead of aiming for wealth maximisation.
Understanding how much you need to achieve this goal means that you’re able to calculate your required rate of return, based on factors such as your starting balance, your additional contributions and the time you have to reach your goal. This required rate of return informs the risk that you must take in your portfolio – this is a very long way of saying that it is completely dependent on your circumstances and the amount of risk you are able to take.
[Editor’s note: Do not read the following company or ETF references as recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article].
For those who want to increase or mitigate resource-sector exposure, we can look to Exchange Traded Funds (ETFs) where the composition of the underlying assets can change the risk and return dynamic.
The SPDR® S&P/ASX 200 ETF (ASX: STW) covers the top 200 stocks. Its weighting is based on market capitalisation and its composition mimics the heavy weightings towards resources that are synonymous with the Australian market.
Some 47%* of its assets are in its top 10 stock holdings in the index – so, highly concentrated. Conversely, some investors may want to diversify their holdings from a single sector. This might include those in retirement, or those that are nearing the end of their time horizon for their goal.
For those investors who want to diversify their holdings but still want exposure to Australian markets, an equal-weighted ETF such as VanEck Australian Equal Weight (ASX: MTW) is a consideration This ETF only covers the top 100 stocks, and the allocation to basic materials is around 17.5%*.
An investor may consider choosing an equal weighted ETF if wary of overexposure or concentration risk in resource shares. Investors may instead consider choosing a market-capitalisation-weighted ETF if they have a longer time horizon.
*as at 17 May 2022
This article has been prepared by Morningstar Australasia Pty Ltd (AFSL: 240892). It has been provided for information purposes only and does not constitute financial advice. The information is general in nature and does not consider the financial situation of any individual. For more information refer to our Financial Services Guide at www.morningstar.com.au/s/fsg.pdf. You should consider the relevant Product Disclosure Statement and contact a professional financial adviser before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance.