Three Reasons Why Commodity-Related Debt May Hold Value Under Pressure
SUMMARY
- Commodity prices have come under pressure due to slower-than-expected growth outside the U.S., divergent monetary policies resulting in a stronger U.S. dollar and lower-than-anticipated inflation.
- The sell-off in commodities and commodity-related debt, as well as related currencies, may be a short-term dislocation that offers value opportunities to bond investors.
- A flexible, opportunistic multisector bond strategy is one solution to take advantage of these value opportunities.
Investors have historically turned to commodity-related assets as a hedge against rising inflation. But despite expectations that inflation will rise in the near future, weak economic growth in the eurozone, Japan and China, as well as a stronger U.S. dollar, has had a negative effect on commodity prices. The volatility in the commodity space may create buying opportunities in commodity-related debt. However, the challenge will be in finding good long-term value.
A multisector bond strategy may be one solution. In this Insight, we explain how our strategy can be applied to find value in commodity-related credits after recent volatility in the sector. We begin our discussion with a focus on how and why we utilize price as a signal for finding value opportunities.
What does price mean to you?
As opportunistic bond investors, we embrace uncertainty in order to find opportunities. A hallmark of our multisector bond approach is taking a longer-term view in order to take advantage of short-term dislocations. In our view, opportunistic means conducting thorough, rigorous research in order to recognize market inefficiencies. We then seek to capitalize on these opportunities.
For us, price can be a powerful indicator of value. Securities prices fall sharply when investors extrapolate bad news into a worst-case scenario. In some instances, the price of a security portends a situation that, in a probability sense, is less likely. In these times of short-term dislocations, we use price as a signal that value opportunities may exist. We assess the probability of an outcome and compare it to what the price of a security is suggests is the likely outcome.
Let’s apply this simple concept to the commodity market. During the third quarter of 2014, commodity-related assets fell sharply, as Exhibit A shows. The consensus view of commodities, we think, has been set with a worst-case scenario in mind. While commodity prices dropped sharply during the quarter, there has been no change in the underlying fundamentals of some commodity-related companies. As bottom-up bond pickers, this is a scenario that piques our interest.
Why have commodities declined so sharply?
We see three reasons why commodity prices have dropped sharply, which also double as reasons why we’re attracted to the sector:
- Expectations for global growth have fallen.
- The U.S. dollar has rallied over the past year.
- Central banks around the world are pushing for higher inflation, but inflation simply hasn’t arrived.
We like to think of commodity prices as the world’s speedometer; when global growth is rapid, commodity prices have historically climbed as well, and vice versa. For example, industrial metals like nickel fell sharply in price after the International Monetary Fund (IMF) said it expects China’s economy to grow 7.1% in 2015, a slowdown from its own prediction of 7.4% in 2014. We also think that the concept of demand destruction comes into play, particularly with greater supply of several commodities made available. With lower world growth predicted for 2015, expected demand for commodities has been reduced. With greater supply of commodities and lower global demand, many commodities, like crude oil, have dropped sharply in price.
Commodity prices have also been influenced by inflation, or a lack thereof. Historically, commodities have served as an inflation hedge. There are plenty of reasons for concern over rising inflation; central bank activity around the globe has been aimed at spurring higher inflation. The U.S. Federal Reserve (Fed) has used large-scale asset purchases (known as quantitative easing, or QE) to keep interest rates low and to stimulate inflation. More recently, central banks in Europe and Japan have been utilizing ultra-accommodative policies to increase inflation.
The problem: Higher inflation simply hasn’t arrived. U.S. inflation readings have instead come in below the Fed’s 2% target. Compounding the issue is the inverse relationship commodities have historically had with the value of the U.S. dollar. The divergence in policies between the Fed and other central banks may result in the U.S. dollar strengthening further. The dollar’s rally, highlighted in Exhibit B, has led to pressure on commodities prices.
It’s worth noting that the U.S. dollar has historically rallied in response to higher interest rates, so investors should have expected commodity-related assets to come under some pressure. This is all part of the market adjusting expectations for when the Fed raises short-term interest rates. However, the strength of the U.S. dollar had us wondering if the sell-off in commodities is due to expectations of a worst-case scenario.
We also want to emphasize that we are not “theme” investors from a top-down perspective, unlike other multisector strategies. We aren’t making a call on whether the dollar will go higher or lower, nor are we saying the dollar’s movement is correct or incorrect. We are simply questioning whether commodity prices at these low levels reflect a worst-case scenario compared to the probability of those events actually playing out as currently priced in.
Finding value in commodity-related debt and currencies
Commodity-related credit is a category that includes a broad array of issuers, both corporate and sovereign, whose balance sheets are effectively backed by real assets such as gold and timber. Much like the actual commodity, such debt may serve as an inflation hedge once the global economy regains steam.
It’s true that inflation is not rising as fast as the Fed would like, but the U.S. is far from experiencing a deflationary environment. With inflation slowly increasing, we think it may be time to consider companies that are backed by real assets. As detailed, these assets should hold up better in an environment of higher inflation, in our view, and that value should rise over time.
Because we are fundamental, bottom-up bond pickers, we analyze individual credits and make investment decisions based on that research. Not every commodity-related credit may be worthwhile; we look for issuers that have strong growth prospects. If an entity is growing, we think the balance sheet will be in a better position.
In addition, we are interested in currencies that have weakened substantially against the U.S. dollar, such as the New Zealand dollar. Investments in foreign currencies avoid direct U.S. interest-rate risk and have exhibited historical volatility closer to that of bonds rather than stocks. Some foreign currencies have historically exhibited low correlation to many traditional asset classes and also provided a hedge against the decreasing purchasing power of the U.S. dollar (i.e., inflation).
Use a professional bond manager
Finding value opportunities in short-term market dislocations, like the one we currently see in commodity-related debt, requires experience and proper expertise. One potential advantage of utilizing a professional manager is gaining access to the manager’s ability as a tactician.
Demand or supply in the commodities market could change swiftly, requiring investors to move deftly so as not to miss a reversal in commodity prices. For example, demand for commodities could rapidly increase if stimulus measures around the globe result in accelerating global growth. On the supply side, producers could cut production, which could lead to an increase in prices.
A flexible manager may be able to add value by being closer to the pulse of the markets, working with traders to recognize opportunities and to nimbly move to where opportunities may be.
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The views expressed in this Insight are those of Kathleen Gaffney and are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.
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