Commodity slump calls for rebalancing

By Vikram Barhat | May 20, 2011 | Last updated on May 20, 2011
4 min read

Commodities markets have been plagued with volatility over the past few months. A tactical move, say experts, would be to peel off commodity exposure and reallocate funds to high yield bonds.

“It makes sense to pare back some exposure to commodities,” says Alfred Lee, vice-president and investment strategist, BMO Asset Management. “Over the course of the last few years, commodities have been on a really strong run—it doesn’t hurt to take profits on some of your commodities positions at this point.”

Cutting back on commodities makes even more sense considering “commodity volatility is going to be pretty high for the remainder of the year.”

Where then should the smart money be going? Lee has some options in areas that tend to be less volatile. Over the short term, he says, investors can reallocate to Canadian REITs, corporate bonds, and U.S. junk bonds.

“U.S. high yield is an area that does look pretty good,” he says. “There’s a lot of appetite for high yield bonds right now; this is certainly an area we’ve been recommending over the last several months and it’s an area investors may want to reallocate some of their commodities positions to.”

That is not to suggest investors overlook the cardinal rule of asset allocation: diversification, the fulcrum of portfolio management. No matter what the economic climate or market conditions, investors should always be diversified, he says.

“Canada is so dependent on commodities, most people tend to be overweight in energy and materials because by nature that’s what our market is,” says Lee. “We recommend that clients always stay diversified, to be well-rounded and have exposure to different sectors by going outside Canada.”

He recommends clients fully diversify not only on a sectoral basis, but also from a global perspective and across asset classes.

“During times of extreme panic, correlation tends to go up, so not only do you need to be diversified across global equities, you need to be also diversified across asset classes,” he says. “That means having exposure to fixed income at all times, despite it paying really low yields rights now. Fixed income is an essential asset class just for that negative correlation in times when you most need it.”

And don’t forget to remain currency hedged—at least for the time being. The strength of the Canadian dollar is tied to commodity prices because a lot of our exports are derived from oil, material and precious metals.

“We think commodity volatility is definitely going to have an impact on the loonie,” says Lee.

Feeling the pressure from the global exit from equity and commodity markets, the Canadian dollar had hit a seven-week low against the U.S. dollar earlier this week.

“What’s really been driving commodity volatility over the past several weeks is the CME Group [which] recently raised margin for a number of commodities, especially silver and oil, so over the short term the commodity volatility is going to translate into a lot of volatility in the Canadian dollar and the U.S. dollar.”

The two dollars are almost complete opposites in that the loonie tends to do well when the prospects for global growth do well, for when that happens commodities tend to do well.

The U.S. dollar, on the other hand, tends to act more as a safe haven currency. Fundamentally, however, the greenback really doesn’t make sense as a safe haven, “because the interest rates in the U.S. are so low, people are using the U.S. dollar as the funding currency for the [currency] carry trade.”

When the market sells off, investors liquidate their positions and pay back their loans, which are in the U.S. dollar. “So the USD tends to appreciate when the appetite for risk goes down; that’s what we’re seeing right now.”

Lee says in the short-term the Canadian dollar will be very volatile against its U.S. counterpart, but that over the long term, the loonie will remain strong because of the fundamental strength of the Canadian economy.

Canada is one of the strongest countries among the G-7 nations. The World Economic Forum has recognized Canada’s banking system as being the most sound in the world. The Bank of Canada backs the Canadian dollar and that is a huge advantage.

“Another driver in terms of currencies is the interest rate differentials and right now the Bank of Canada is expected to raise rates before the U.S. Federal Reserve which is going to cause the Canadian dollar to be more attractive to the U.S. dollar over the long term as well.”

Vikram Barhat