Coming off the weak but unusual period in late 2018, commodities advanced sharply in early 2019, driven by a rapid advance in crude oil prices globally. Although there was a fair amount of volatility in the mid part of the year due to geopolitical concerns (trade and tariffs, Middle East conflict, etc.), commodities rallied strongly in the fourth quarter leaving the Rogers International Commodity Index® methodology (“RICI®”) up +11.8% for the year. This was significantly ahead of the benchmark Bloomberg Commodity Index (up +7.69%) and represented the fourth year in a row of outperformance. As we referenced in last year’s commentary, we believed that the sudden and primarily energy-related decline during the fourth quarter of 2018 was idiosyncratic, and commodities would recover and improve over the course of 2019 (commodities-off-to-a-strong-start/). This proved to be the case, continuing the longer-term rally in commodities that commenced in early 2016.
Although the energy sector continued to exhibit higher than normal volatility, the sector performed well over the course of the year (RICI® Energy Sector +23.25%). Industrial and precious metals also performed well, with the RICI® Metals Sector up +9.38%. Although positive, agriculture/softs did not contribute meaningfully in 2019 (RICI® Ag Sector +0.13%).
Despite the many crosscurrents during the year, it was a broad-based increase for the commodity asset class with almost 2/3 of the components in the RICI® positive by year end 2019. As seen below, at least one component from each sector was included in the 5 best and bottom 5 performers. We consider it a healthy market when individual commodities are trading on their own fundamentals.
As in previous commentaries, we always call attention to the fact that commodity recoveries, once underway, are typically multi-year in duration, and that the rally in commodity prices could continue for some time. It’s also important to mention that, although commodities have rallied in 2016, 2017, and 2019, commodities are by any measure inexpensive, averaging 47% below former peak prices for the 38 RICI® Index components over the last 21 years since the Index’s inception (Significant Recovery Potential Chart). Even more importantly, commodities are the most undervalued relative to U.S. equities that they have been in over 50 years. This level of valuation imbalance between stocks (at record prices) and commodities (below cyclical means) has almost always been followed by a dramatic reversal in favor of the commodity asset class. During periods of relatively low inflation, the rationale for a continued commodity rally can be hard to anticipate. However, as we have also noted in the past, commodities tend to mean revert without regard to macroeconomic forces and seem to move on their own before the fundamental drivers are readily observable which was the case off the bottom in 1999 (time-to-party-like-its-1999).
As a reminder, our methodology calls for us to add to positions that have declined, rebalancing back to initial index weights on a monthly basis, meaning we are always fully invested at index methodology levels. The methodology also requires that we partially sell temporarily outperforming commodities, which allows for profits to be taken from the portfolio. This discipline has served the Fund well over time. The Fund outperformed the benchmark Bloomberg Commodity Index again in 2019, by +242 basis points, net of all fees and expenses.
Despite the current pause in Fed tightening policy, the outlook for interest rates should also be considered a positive for commodity fund performance expectations. As rates increased throughout 2018, the contribution to total Fund return of the collateral account, consisting of short-duration US T-Bills and government money market equivalents, became more meaningful. For 2019, this was reduced somewhat by a series of Federal Reserve rate cuts. The current flat yield curve means that the collateral account is earning a rate of interest at or above longer-term US Government securities rates.
We believe the outlook for commodities continues to be decidedly positive, and that the RICI® methodology represents one of the best and most diversified ways of investing in the overall asset class.
The Long Term Opportunity
The commodity asset class remains out of favor and we believe underweighted in institutional portfolios. This is not surprising given the bear market of 2011-2015, In addition, the recovery from what we believe to be a secular low in early 2016 has been uncharacteristically muted thus far while financial assets have appreciated considerably. However, reversion to the mean can be a powerful force in portfolio management and at the present time, investors have the opportunity to add this asset class while prices are deeply depressed both on an absolute basis and relative to financial assets.
A Global Demand-Based Portfolio
The RICI® is a composite, US dollar-based, total return index methodology. It represents the value of a basket of commodities consumed in the global economy, ranging from Agricultural to Energy and Metal products. The Index’s weights attempt to balance consumption patterns worldwide (in developed and developing countries) and specific contract liquidity. The value of this basket is tracked via futures contracts on 38 different exchange-traded physical commodities, quoted in four different currencies, listed on nine exchanges in four countries.
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