What to do with commodities and emerging markets

The global commodities1 and emerging market equities2 segments of diversified portfolios have been the source of client questions for many advisors lately. Both asset classes have been dragging down returns of diversified portfolios and have been trading below their respective historical 1-year return averages for over 5 years. What’s driving these results and how can advisors respond to clients?

Talking points on commodities

As of this writing, oil is priced at approximately $30/barrel – which is nearly 5 times lower than its high point in 2008 of $145/barrel.3 The precipitous drop in 2015, and again in the early part of 2016, has caused alarm among many investors, particularly as it has impacted the performance of many commodity-related investments. Global Commodities Chart 2 Global Commodities represented by the Bloomberg Commodity Index

It’s a demand/supply story

From an economic standpoint, the price decline reflects a supply/demand imbalance. Once that imbalance corrects, commodities are likely poised to rebound to more normal ranges (or potentially even higher).

Commodities is more than oil

Plummeting oil may be grabbing headlines, but it’s worth recalling that commodities are made up of more than simply oil. Within the Bloomberg Commodity Index, Energy accounted for only 30% of the total index as of December 2015. Industrial metals, precious metals (including gold), and agriculture – which together made up 65% of the index in December – have held up better. For example, sugar, soybean oil, and lead had positive returns (18.4%, 10.6%, and 7.1%, respectively) during the 4th quarter of 2015. In fact, year-to-date through January 27, diversified commodities4 are no longer the worst asset class in a diversified portfolio. They have outpaced U.S. equities,5 non-U.S. equities6 and global REITs.7

Commodities outlook

Many oil industry experts anticipate that the price of oil could be back at $60 barrel in 3 years – double where it is today.8 If that scenario plays out, the investment return on that asset class could be 26% per year. More conservative pundits believe it may take 5 years to get back to $60/barrel.9 If that were the case, the annualized return on the asset class would be 15% by February 2021. Either way, I believe considering the price of oil over a 3 to 5 year time horizon – as opposed to a daily frequency – may help investors appreciate the potential opportunity for maintaining modest allocations to commodities today.

Talking points on emerging market equities

Emerging markets10 have underperformed developed markets11 by a considerable amount over the last 5 years ending December 2015. Emerging market countries’ sensitivity to external factors like depressed commodity prices, the strong U.S. Dollar and Fed tightening have all contributed. Accounting for 27% of the MSCI Emerging Markets Index as of December 2015, China certainly has a large impact on emerging market returns. As the Chinese economy’s growth has slowed (from double-digit to ~7% GDP growth today) so has its consumption of oil, metals and other commodities. That softening demand from China and elsewhere has put pressure on commodity prices, causing commodity-sensitive emerging market countries (like Russia, Brazil, South Africa, Chile) to suffer. Bear in mind, though, that emerging markets are not monolithic. Investment opportunities within that grouping of countries are not limited to China. For instance, India represents 9% of the MSCI Emerging Markets Index, is a net importer of energy (and hence has benefited from lower energy costs), and has other attributes that make it appealing for some long-term investors with commensurate risk tolerance. Active managers can look for those companies that may have attractive valuations and equally attractive growth opportunities. That being said, China will continue to be in the news. The Chinese government is trying to navigate a smooth transition from an export-led economy to a consumer-led one. That wouldn't come without some growing pains. See our most recent Consider this for more. While emerging markets continue to face shorter-term cyclical challenges, their valuations are attractive and warrant watching buying opportunities for the long-term diversified investor. Emerging Markets Chart 2 Emerging Markets represented by the MSCI Emerging Markets Index.

The bottom line

So what to do with emerging markets and commodites? Given their track record the past 5 years, the temptation to abandon these asset classes is high. However, I would argue that the time to abandon those investments would have been 5 years ago. Selling them now would lock in the losses, and it would cause investors to miss out on any eventual rally in energy. Will we continue to see volatility in the short term? Most likely, yes. Do commodities and emerging markets still belong in a diversified portfolio? Yes, for those investors with the appropriate level of risk tolerance. Remind the capitulators in your book that long-term wealth is rarely created by selling low.

1 Represented by the Bloomberg Commodity Index

2 Represented by the MSCI Emerging Markets Index

3 WTI Crude, Source: U.S. Energy Information Administration

4 Represented by the Bloomberg Commodity Index

5 Represented by Russell 1000® Index

6 Represented by MSCI EAFE Index

7 Represented by FTSE EPRA/NAREIT Developed Real Estate Index

8 U.S. Energy Information Administration’s Short-Term Energy Outlook and Annual Energy Outlook

9 U.S. Energy Information Administration’s Short-Term Energy Outlook and Annual Energy Outlook

10 Represented by MSCI Emerging Markets Index

11 Represented by MSCI EAFE Index