Commodity-linked products seen as suitable hedge as inflation fears take hold of markets

Singapore

INFLATION fears have been sweeping over markets, as countries around the world begin reopening their economies after the Covid-19 pandemic. Some market strategists say commodities could be a suitable hedge in an investor's portfolio, and could even be entering a supercycle fuelled by structural demand. But there are also warnings of risks from volatility as well as the still-uncertain longevity of present inflationary pressures.

Ole Hansen, global head of commodity strategy at Saxo Markets, said the current combination of rising inflation and a global economic recovery means the commodity sector has become a "favourite go-to market for hedging opportunities".

"While money can be printed at a pace decided by central banks, the finite availability of commodities has historically ensured that prices would follow or in most cases exceed the level of inflation," he said.

Beyond investing directly in single commodities, which may be challenging for individual investors, "numerous vehicles" linked to commodity prices exist, said Chris Iggo, chief investment officer for core investments at AXA Investment Managers.

Among those he noted were contracts for differences (CFDs) for individual commodities; mutual funds; and equities linked to the commodities business, such as mining companies, or to the energy or transportation industries.

Shaniel Ramjee, a senior investment manager at Pictet Asset Management, added to this list the debt instruments of commodity-related companies, and the currencies and credits of commodity-rich countries.

Other more diversified options would include exchange-traded products designed to track the performance of a basket of commodities, such as the Elements series of exchange-traded notes linked to the Rogers International Commodity Index and its sub-indices.

At Saxo, one popular option among clients is commodity exchange-traded funds based on the Bloomberg Commodity Index. This is due to its "broad exposure across the three sectors of energy, metals and agriculture", said Mr Hansen.

Commodity swaps are derivative contracts with a pre-agreed price or pricing mechanism based on the price of an underlying commodity.

The S&P GSCI and the DBIQ Optimum Yield Diversified Commodity Index are two other alternatives.

Said Mr Hansen: "We recommend a broad exposure as we want to have decent exposure to metals (both industrial and precious) while avoiding excessive exposure to the energy sector, where the price action is more dependent on political decisions than supply and demand."

Analysts at UOB Kay Hian (UOBKH), meanwhile, see certain market trends driving demand and prices for some commodities above their long-term average.

Aluminium, for example, is in higher demand because it is a so-called greener metal. It is also becoming the preferred metal for electric vehicles (EVs), due to its lighter weight, and it is used in batteries. Another metal used in the manufacture of EVs is copper, which is also used in solar panels. Then there is tin, which is used in solders in many electronics.

Among the Malaysia-listed stocks with exposure to these metals, UOBKH believes Press Metal is in a "sweet spot". Press Metal is among the largest integrated aluminium producers in South-east Asia.

The counter also "best fits into the ESG investing target" as it uses hydro power as an energy source instead of coal power, the brokerage added. UOBKH has a "buy" call on the stock with a target price of RM6.30. Press Metal shares closed flat at RM5.20 on Monday.

UOBKH also has a "buy" call on Malaysia-listed Cahya Mata Sarawak (CMS), which could be an indirect beneficiary of higher prices via its 25 per cent stake in OM Sarawak. The latter is a greenfield smelter complex that produces ferrosilicon and manganese alloys.

Beyond UOBKH's coverage, other Malaysia-listed potential beneficiaries are JAG, which has exposure to copper, and integrated tin producer Malaysia Smelting Corp. The latter is also listed on the Singapore Exchange (SGX). SGX is also host to Fortress Minerals, which on April 7 completed the acquisition of Malaysian iron ore and copper producer Monument Mengapur.

Investors hoping to double up on their exposure to commodities should, however, be aware of several risks. Christina Woon, an investment manager for Asian equities at Aberdeen Standard Investments, warns that the "underlying drivers" for various commodities are different. This means a lack of proper understanding could drive up any risk of a hedge not working out. "For example, in order for the energy sector to go further from here, one of the things you need is a recovery in transport and travel, which looks like it will take a while to play out. There are also other demand headwinds to consider, such as the world's shift away from dirty fuels," said Ms Woon.

Investors looking to de-risk, she said, should consider miners that are well-placed on the cost curve and in high-grade products. These players should also have higher environmental standards, or be involved in commodities that are "on the right side of climate change".

"These companies would also need to have sufficient scale, well-run management and strong balance sheets to weather cycles," she added.

Also, while commodities can act as a hedge, Rabobank's head of agri commodity markets research Carlos Mera warned that they are "not a perfect one". Said Mr Mera: "Commodities are always very volatile and subject to supply-demand shocks, so investors looking for a hedge against inflation might consider a broad basket but probably avoid those commodities that are usually in contango (like wheat and arabica coffee)."

Contango is a situation in which the future price of a commodity is higher than the spot price.

The current inflationary environment is also different from previous ones, warns Chris Midgley, global director for analytics at S&P Global Platts. "Unlike previous cycles, this is being driven by the fiscally stimulated consumer spending," he said, adding that commodity prices are consistently volatile and "far more dependent on consumer trends, production costs and regional geopolitics".