Fund Management Diary Meeting held on 10 th July 2018 Does the oil price determine other commodity prices? The price of oil has surged this year and held on to its gains in recent weeks even as many commodity prices have come under downward pressure due to escalating concerns about a trade war Historically, oil and non-oil commodity prices are positively correlated but a boost to non-oil commodity prices would require oil prices to remain high Capital Economics expect oil prices to fall by the end of this year and again in 2019 as production picks up. They expect industrial metals prices to stabilise after recent steep falls but to remain subdued due to slowing Chinese demand growth. They see gold receiving support from its safehaven status and agricultural prices being underpinned by a deteriorating outlook for supply Oil prices have diverged from other commodity prices in 2018 Since the start of the year, the price of Brent crude oil has risen by 15.7 per cent from $67 per barrel to $77 per barrel which, given its high weighting, has driven a strong performance in global commodity price indices. The S&P GSCI commodity index has risen by 8.7 per cent which contrasts with the 0.6 per cent decline in the MSCI World index. Much of the recent strength in oil prices has been fuelled by concerns about supply, which perhaps partly explains why the rise in oil has not been mirrored in other commodity markets. The S&P GSCI measure of industrial metals prices has fallen by 10.4 per cent since the start of the year while that for precious metals is 4.3 per cent lower. Admittedly, the prices of many agricultural commodities did rise from January through to the end of May, but they have since fallen back as a result of escalating trade tensions between China and the United States. Historically, there has been a strong positive correlation Over the longer term, however, there appears to be a closer relationship between price moves in oil and other commodities. The correlation coefficient which can range from -1, signifying a perfect inverse relationship, to +1, signifying a perfect positive relationship between oil and other commodity prices is positive and high. Since the start of 2000 the correlation coefficient between daily crude oil and industrial metals prices is 0.81, with that for precious metals prices being 0.78 and that for agricultural prices being 0.89. While oil prices have been more volatile, the big picture is that the non-oil commodity indices and oil typically move in the same direction. Capital Economics thinks the correlation can be explained by three key factors. First, oil is an input in the production of many commodities so moves in the oil price affect the cost of production (and ultimately the price). This is particularly the case with agricultural commodities where oil prices affect the costs of producing agricultural chemicals (including fertilisers), powering farm equipment and transporting produce. Using data for the United States in 2016 from the United States Department of
Agriculture, Capital Economics estimate that oil-based goods account for between 45 and 65 per cent of the production costs of major crops (excluding fixed assets, such as land). Oil is also a cost of production for the mining and metals sectors. What s more, there is some particularly energy-intensive primary processing of metals, notably aluminium. Not surprisingly, the prices of oil and aluminium show a relatively high correlation of 0.65. Even though oil itself is not powering metal smelters and refineries, moves in the oil price often prompt similar moves in other energy commodities, particularly natural gas. However, aluminium is more the exception than the rule. The relationship with oil and metals prices appears weaker than that for agricultural commodities. This can probably be explained by the fact that, owing to their larger scale, mining and metals companies are better placed to negotiate long-term deals to buy their electricity. This gives them more insulation from the short-term volatility in oil prices. In addition, transport costs are typically lower than for agriculturals as metals (apart from iron ore) are not as bulky as grains. Moreover, the price of oil can be a driver of a commodity s price if oil is an input to production of substitutes for that commodity. This is the case with the competition between man-made fibres and cotton and between synthetic and natural rubber. Oil prices are also a key determinant of the price of biofuels, which compete with refined petroleum. Second, trends in economic activity are a key determinant of demand for both oil and the more industrial commodities. This common demand driver can cause prices to move together. The impact of economic activity on agriculturals is more nuanced. Staples, such as wheat and rice, may benefit from an economic downturn rather than an upturn. Meanwhile, demand for coffee and cocoa typically increases when the economy is performing strongly and disposable incomes are rising. Third, the financialisation of commodity markets has led to greater correlation at times. When investors are comfortable with holding a risky asset like oil, they will be more inclined to hold other commodities too. Furthermore, all commodities but most notably gold are considered to be hedges against inflation. If oil prices rise, this is likely to feed through to higher inflation expectations and could prompt buying of gold (in particular) but also other commodities as a hedge. A final way in which the markets can push non-oil commodities in the same direction as oil is by the trading of commodity indices. Although oil accounts for a significant proportion of the indices, investors will also have exposure to most other commodities. So what does all this mean for commodity prices going forward? Capital Economics has made the case that the recent rise in oil prices could put upward pressure on all commodity prices in the medium term. This begs the question of why they remain quite bearish on the outlook for the prices of metals and expect agriculturals to largely tread water from here. The simple answer is that Capital Economics forecasts that the price of oil will fall back as fears over supply prove unfounded and growth in demand softens. They expect the price of Brent crude oil to fall from nearly $80 today to $65 per barrel by the end of this year and $55 per barrel by the end of 2019. The more detailed answer is that Capital Economics has been expecting industrial metals prices to fall due to their view that China s economy will slow in the remainder of this year. While this is also a factor in the lower oil price forecast, China is a more powerful driver of demand in the metals markets than in the oil
market. With the S&P GSCI industrial metals price index having fallen by 12.5 per cent over the past month much of the forecast decline has been realised. Capital Economics now expect prices to stabilise around this lower level. Tightening of monetary policy in the United States by the Federal Reserve will continue to act as a headwind to the price of gold, but Capital Economics think that rising demand for safe-havens and inflation hedges will lead to some upward pressure on the gold price by end-2018. Finally, for agriculturals, China s key imports from the United States include soya beans, cotton and, to a much lesser extent, corn. These products have been targeted in the first round of Chinese retaliatory tariffs, resulting in lower international prices. Capital Economics expects that the recent drop in these agricultural prices will curtail supply in 2018-19 which will act as a floor under prices. *This diary has been written in conjunction with Capital Economics. Strategy Brexit has been dominating headlines over the last few days, following the announcement of the Chequers plan and the resignation of both David Davis and Boris Johnson. The Margetts team have discussed these developments and believe that these developments mean there is no longer a middle ground available to us in the Brexit negotiations, and that a very soft or a very hard Brexit are now the only options available to the UK. We believe that binary outcomes such as this one make portfolio management difficult as the potential outcomes are so different. Our core investment strategy remains unchanged when markets appear particularly fragile we would rather remain invested and endure some volatility than potentially lose out on any positive upside.
Fund Comments The below charts show the current positions of the fund, the tactical (short term) targets, and the strategic (long term) targets of the fund. We aim to keep the current positions in line with the tactical targets from week to week. The differences between the tactical and strategic targets reflect the views and convictions of the Margetts Investment Committee. Providence 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Bonds Cash UK Europe ex UK North American Asia Pacific ex Japan Emerging Markets Japanese Global Current Position Tactical Targets Strategic Targets Asset Allocation: The above chart, as of 06/07/2018, demonstrates the fund s current asset allocation and the tactical targets set by the committee. No changes are being made to the tactical targets or current allocations this week. Fund Selection: The L&G Asian Income has outperformed its IA sector over recent months, which is likely to be due to its overweight to Australian equities which have performed relatively well. In the UK equity selection, the Threadneedle UK Equity Income had a very strong quarter, mostly due to its overweight to the Industrials sector.
Select 50.0% 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Bonds Cash UK Europe ex UK North American Asia Pacific ex Japan Emerging Markets Japanese Global Current Position Tactical Targets Strategic Targets Asset Allocation: The above chart, as of 06/07/2018, demonstrates the fund s current asset allocation and the tactical targets set by the committee. No changes are being made to the tactical targets or current allocations this week. Fund Selection: Henderson Emerging Markets Opportunities continues to stay ahead of its peer group, mostly due to its underweight to Chinese stocks. Meanwhile, BlackRock Asia has lagged its IA sector due to an overweight to Chinese equities, however the Schroder Asian Income fund has performed better, and we believe these two funds work well as a pair, as they typically outperform at different times. The Invesco Perpetual European Equity Income fund has had a good month compared to the IA sector, following on from relatively weaker performance in previous months.
International 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Bonds Cash UK Europe ex UK North American Asia Pacific ex Japan Emerging Markets Japanese Global Current Position Tactical Targets Strategic Targets Asset Allocation: The above chart, as of 06/07/2018, demonstrates the fund s current asset allocation and the tactical targets set by the committee. No changes are being made to the tactical targets or current allocations this week. Fund Selection: The Baillie Gifford Pacific has lagged its IA sector over recent months, mostly due to it bias to Chinese equities. Meanwhile, the L&G Asian Income fund has performed better, due to its heavier Australian allocation. The Threadneedle UK Growth & Income fund has performed very well over the last quarter, mostly due to its overweight to the Industrials sector.
Venture 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Bonds Cash UK Europe ex UK North American Asia Pacific ex Japan Emerging Markets Japanese Global Current Position Tactical Targets Strategic Targets Asset Allocation: The above chart, as of 06/07/2018, demonstrates the fund s current asset allocation and the tactical targets set by the committee. No changes are being made to the tactical targets or current allocations this week. Fund Selection: The Stewart Asia Pacific Leaders fund performed much better than the IA Asia Pacific ex Japan sector over recent months, mostly due to its very large underweight to China. Henderson Emerging Markets Opportunities continues to stay ahead of its peer group, also due to its underweight to Chinese stocks.
Important Information Please note that the contents are based on the author s opinion and are not intended as investment advice. This information is aimed at professional advisers and should not be relied upon by any other persons. Any research is for information only, does not constitute financial advice or necessarily reflect the views of the author and is subject to change. It remains the responsibility of the financial adviser to verify the accuracy of the information and assess whether the fund is suitable and appropriate for their customer. Past performance is not a reliable indicator of future performance. The value of investments and the income derived from them can fall as well as rise and investors may get back less than they invested. Important information about the funds can be found in the Supplementary Information Document and NURS-KII Document which are available on our website or on request. Issued by Margetts Fund Management Ltd Margetts Fund Management Limited is authorised and regulated by the Financial Conduct Authority For any information about the company or for a copy of the company's Terms of Business, please contact the company on 0121 236 2380 or at 1 Sovereign Court, Graham Street, Birmingham B1 3JR You can e-mail us at admin@margetts.com