Investors are grappling with how to best position portfolios for what many experts believe is the latter part of the business cycle, writes J.P. Morgan's Kerry Craig.

Commodities, namely oil and gold, have been classic late cycle plays. Investors may dismiss the use of historical comparisons given the structural changes in markets and economies this time around. However, history still proves to be useful guide and offers some rules of thumb on how these two asset types may perform heading into the next economic downturn.

This year has been a mixed bag for commodities performance. The broad Bloomberg Commodities Index ended the first half pretty much flat, as rising oil prices were offset by declining metal prices.

The steady fall in the price of gold since April may come as a surprise, given its "safe-haven" status - at a time when tail risks have been rising and investors nerves increasingly frayed. However, many of the bastions of safety for investors are yet to signal an impending doom.
Certainly, US government bond yields have struggled to break through 3 per cent, although they are well off historical lows.

Meanwhile, the Yen and the Swiss Franc, which are traditional safe havens in periods of stress, are yet to be the recipients of significant flows seeking shelter.

US federal reserve

The Fed has persisted in hiking rates despite risks posed by trade and geopolitics


King of metals

Why is it that the gold price is falling at a time when the list of risks has never been longer? Gold is often viewed as the ultimate insurance policy against a market catastrophe, and an allocation to gold has been a fairly consistent late-cycle trade, living up to its "king of metals" moniker.

The value of gold should rise, as the economic outlook deteriorates and real interest rates fall in line with loosening monetary policy. However, in the run up to a recession, the yellow metal can struggle.

Despite risks to the growth outlook from trade and geopolitics, the US Federal Reserve has persisted in hiking rates, lifting real rate interest rates, which in turn has created bursts of US dollar strength, resulting in dual headwinds for gold.

The more likely scenario is that gold will once again perform well once the wheels start to come off the global economy. But the US is a decade into its expansion, and there are no guarantees on when it will end.

There is certainly little sign of a recession in the coming year. Until then, gold looks like an expensive insurance policy in terms of the opportunity cost of holding an asset that could offer greater return potential against a relatively robust growth outlook.

From yellow to black gold

Having a position in the oil market can lift return potential during the latter stages of the business cycle, when demand is usually running above supply and there may be looming capacity constraints limiting future supply.

Geopolitical risk, an all too familiar influence in today’s markets, can add to the upside as sharply rising prices reflect anxieties over supply, as was the case in the 1970s. However, it’s a double-edged sword. Rising oil prices can artificially end the cycle as central banks react to higher inflation and consumption is dampened.

Commodities is one of these broad groupings which belies the traits of the underlying components. Not every commodity will perform at the same time. While gold needs clear evidence of an imminent recession, the oil market will have already retrenched given the anticipated decline in demand.

The upside to the oil market may not be as great this time around. The increased cooperation between OPEC and Non-OPEC members on production targets suggests that supply outages can be covered by other OPEC members. Meanwhile, an increasing share of global production is coming from US shale, which has proven very responsive to price changes.

The deterioration in relations between Iran and US mean that a spike in oil prices can’t be ruled out. But capacity constraints are not as evident now as in past cycles.

There is plenty to keep investors on their toes and many of the mini-shocks experienced this year may feel amplified against the late cycle dynamic.

Economies around the world look robust, if less synchronised, and the corporate back drop is supportive of growth assets.

Additional caution may be warranted, but it’s too early for all-out defensive positioning in portfolios. Commodities will have a role to play when the time comes, but that time is not now.


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Kerry Craig is a global market strategist with J.P. Morgan Asset Management. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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