Madan Sabnavis: 2012 - The year for commodities?

Given the rather less than sanguine economic conditions, an investor who would like to make an informed guess at various options can look at what happened in 2011 before taking a decision. Conventionally, investment options lie between deposits or government securities (G-Secs) at one end and the more volatile stock market at the other. Also there is a risk-reward trade-off that reflects the investor’s appetite. What are the options today?

Investment decisions can never be guided by the theory of static or adaptive expectations since one can never be sure that what happened yesterday will also happen tomorrow. What is required is the use of rational expectations, that is, using all the information available for taking informed decisions. This is what got Thomas Sarjent the Nobel Prize and can be applied today on the premise that markets are efficient, where the market price reflects ex post all the information that is available.

The table provides comparable returns for 2011. Annualised price volatility is calculated by the standard deviation of daily returns, while total returns have been reckoned in two ways: an investor buying the product on the first day of January 2011 and selling on the last day of 2011 or a trader buying and selling everyday where the annual return is the sum of daily returns.
 

RETURNS ON ASSETS
Product	Annualised volatility (%)	Annual investor return (%)	Annual trader return (%)
Rs/$	8.38	18.79	17.93
Nifty	21.10	-24.90	-26.47
GSec total return index	10.38	3.68	4.35
Gold	20.85	8.93	10.73
Silver	27.69	8.80	16.48
Chana	17.29	32.64	31.43
Soy oil	5.14	14.11	13.65
Crude oil	35.11	10.56	13.60
Source: RBI, NSE, World Gold Council, NCDEX and EIA web sites

The table shows that almost all assets had high volatility with the exception of soy oil and the exchange rate. Further, the investor and trader would have been almost on a par in terms of returns. Also, commodities that are a good risk diversifier were the flavour — chana gave the best returns followed by dollar, silver, soy oil and crude oil. The risk adjusted return would also be very competitive (nominal return divided by standard deviation). Finally, crude and bullion had high volatility though returns were lower than that on chana. Clearly, investors need to look at a diversified portfolio in these volatile times as commodities are intrinsically more efficient because their prices are driven by fundamentals of demand and supply.

Looking at commodities, bullion – which includes gold and silver – are safe harbour investments. Their prices move inversely with that of the dollar and as long as the dollar is fragile will continue to be preferred. The dollar will strengthen due to the euro’s weakness, while the US’ high deficits will keep pulling it down. Gold has historically yielded returns between 10 per cent and 15 per cent a year and that will hold in the coming year.

Farm products are straight options but difficult to understand. In a well-developed market – as it exists on, say, the National Commodity & Derivatives Exchange Limited for chana and soy oil – fundamentals drive prices. Lower production of chana this year has driven up prices, while global pressures on edible oils as well as lower production of soya bean in India has driven prices. However, one has to research these products well, which makes it difficult to understand. The same may not hold in 2012 because prices will be guided by the fundamentals that emerge during the cropping seasons.

Crude oil returns are driven by global demand and geo-political factors. With the passage of winter and generally stable global conditions, at best, demand will not really exert pressure. Further, stable political equations will work to maintain equilibrium that will also be supported by a stronger dollar. Therefore, crude oil would be less attractive than, say, farm products or bullion.

Coming to dollar futures that can be accessed by all, the movements have been an enigma, as the rupee is driven by the dollar-euro relation and our balance of payments. The fundamentals will remain under pressure as the trade deficit widens when imports increase to support growth, while exports struggle in the face of slower global growth as forecast by the International Monetary Fund and the World Bank. This will also slow down capital flows like foreign institutional investors, thus, making the dollar an exciting option. In the pecking order, however, it will still be lower than commodities since the Reserve Bank of India (RBI) factor will be at play to ensure that volatility is limited.

G-Secs will continue to move within a narrow band, thus, giving minimal returns. However, stock markets will be the one to watch out for. RBI’s lowering of rates will make stocks attractive. A progressive Budget – with growth stimulus – will be a booster shot. A possible Greek crisis will spook the markets, while certain trends in the election wave in the US could do the same. Therefore, volatility is bound to remain in this market. However, anecdotal evidence shows that when capital markets boomed and delivered, the economy was also doing very well. It is a necessary though not sufficient condition. With our expectations of a modest recovery this year, the markets can provide better returns than government paper, but will be several steps below commodities.

Therefore, it may just be the right time to get back to the textbook and study the fundamentals of commodities, including farm products that could spice up the investment basket.

The author is Chief Economist, CARE Ratings. These views are personal