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 Bloomberg Commodity Index Total Return: Composed of futures contracts on physical commodities. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, commodity futures contracts normally specify a certain date for the delivery of the underlying physical commodity. In order to avoid the delivery process and maintain a long futures position, nearby contracts must be sold and contracts that have not yet reached the delivery period must be purchased. This process is known as “rolling” a futures position. MSCI Emerging Markets Index: A float-adjusted market capitalization index that consists of indices in 21 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. MSCI EAFE (Europe, Australia, Far East) Index: A free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. FTSE EPRA/NAREIT Developed Real Estate Index is a global market capitalization weighted index composed of listed real estate securities in the North American, European and Asian real estate markets. The Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market. Rolling returns are beneficial for understanding the behavior of returns over multiple time periods as opposed to single periods ending at most recent measurement date. For example: 5 year rolling time periods calculated over 10 years captures 61 observations instead of a single 5-year or 10-year measurement period. They can help to demonstrate patterns or longer term trends in return data. Standard Deviation (SD) is a statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. The greater the degree of dispersion, the greater the risk. Indexes are unmanaged and cannot be invested in directly.Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide, including Russell Financial Services, Inc., member FINRA. Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management. Copyright © Russell Investments 2016. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty. RFS 16643