IN the past, commodities were seen as an excellent diversification tool for investor's portfolios, providing returns uncorrelated to some extent to the capital markets. In fact, investors usually require from a commodities allocation to offer three key benefits to their portfolios: diversification, return potential and inflation protection. But during the past years, it has gone seriously out of fashion amid challenging performance constrained by demand and supply dynamics. The problem arises by the level of uncertainty investors have with their views on this asset class. Factors like GDP growth, USD gains and geo-political risk have all tainted investors' appetite. However, we believe that investors should not come to a conclusion too early, as commodity returns have a tendency to be somewhat cyclical. While the last few years of commodity returns are not an irregularity, they also have not been normal. Commodity asset class returns tend to go through cycles of good and bad performance, which largely correspond with economic growth cycles. When looking at relative performance of a portfolio containing commodities, this has varied over time, with episodes of underperformance occurring as expected during economic downturns. Investors should note that commodities as a whole are growth-sensitive assets, especially in recessions that overlap with oversupply and weak demand – similarly to the events of the global financial crisis. Importantly, we should note that these periods were followed by years of recovery in commodity returns and the outperformance Since Donald Trump›s surprise US presidential election win, broadly diversified commodity indices have risen, along with some volatility. The rise in prices and volatility is due not only to Trump but also to commodity-specific factors like OPEC agreement on oil production cuts, real US interest rates going deep negative driving the appeal of gold, better global industrial production during 2017 can potentially drive demand growth in industrial commodities. This can also drive the demand for industrially-oriented metals of palladium and platinum. Changes in inflation are also an important driver of commodity price behavior. As in inflation, the very same commodities comprising the asset class that drive the majority of CPI changes. Furthermore, commodities tend to exhibit an outsize response to inflation, meaning that when inflation increases above expectations, commodity returns increase more than the change in the inflation rate. To the extent that inflation surprises to the upside, a commodity allocation can provide a potential hedge against inflation beyond just the original capital amount invested. It is also important to note that commodity returns may be improved through active management. Commodity markets offer a fertile opportunity for active trading and potential for alpha generation for capable investment managers. And while the return benefit of including commodities in a broader portfolio can be cyclical over time, the diversification benefit has remained consistently positive, which leads to better risk-adjusted returns over time. In summary, investors should understand what are the key drivers and sensitivity for each asset class they decide to have or not have in their portfolio. Despite recent performances, commodities should be seen as an important long- term inclusion to investor's portfolio, with the benefits mentioned in this note. * The writer is managing director, Head of Advisory, SEDCO Capital
