Commodities, as measured by the DJUBS Commodities Index, have returned 8.3% year to date to 6 March. This strong performance was driven by one factor – weather, say Alastair Baker and Patrick Brenner, Fund Managers, Schroders…
Whilst weather has the potential to have a negative impact on agriculture prices, 2014 has seen extreme weather put upward pressure on prices. The weather shock came in two parts. First was the severe weather experienced in the US. Demand for natural gas rocketed as it is the primary source of energy used to heat homes in the US.
Inventories of natural gas were drawn down to very low levels, while the volatility of natural gas prices jumped. The worst of the volatility was in late January when it became clear that the cold weather would persist for longer than expected. As this extremely cold weather is a temporary factor and natural gas remains well supplied in the US, we see no reason to change our energy view at present and maintain our overall negative score.
The second component of the weather shock came from South America. This key coffee growing region experienced hot, dry weather, while there was heavy rain the in the soy bean growing regions. This has caused agriculture prices, as measured by the DJ UBS Agriculture Index, to rise by over 16% since the start of the year). The main driver of this move has been coffee, which has rallied 73.9% year to date and accounts for 42% of the overall agriculture index’s return.
Agriculture prices are prone to weather disruptions and one of the key indicators used to predict whether we are likely to experience adverse weather is the El Niño Indicator. An El Niño is when the indicator identifies a temperature change greater than 0.5°C above average, and a La Niña is a change of greater than 0.5°C below average. Historical data going back 50 years suggests that weather disruptions are much more likely to occur when the indicator points to either of these extremes. Therefore, the chance of a supply shock is higher than average and our natural bias should be to expect some agriculture prices to appreciate.
Models are now predicting that an El Niño is likely during the northern hemisphere summer in 2014. As a result of these predications we should be on the lookout for further weather disruptions, with the likelihood that they will persist into the northern hemisphere summer and affect the major crops. We believe there is significant upside for grain prices should the El Niño develop. Considering the potentially severe weather shock, we have moved from a negative to a neutral view on agriculture.
Following the latest series of rate hikes from several emerging market central banks, higher yielding currencies have become more attractively priced. Figure 2 looks at carry spreads both in absolute terms and relative to the yield on US Treasuries. We look at carry spreads for our carry basket (buying currencies with high interest rates and selling those with lower rates) over a five year period to construct deciles. The first decile is where carry is the most expensive in the five year period and the tenth decile is where it is the cheapest. As Figure 3 shows, both the absolute and relative spreads are currently in the tenth decile.
However, while we see value in high yielding emerging market currencies, we remain concerned by a number of factors. High yielding emerging market currencies tend to be heavily exposed to capital outflows associated with the tapering of quantitative easing in the US due to their dependence on external liquidity to fund their current account deficit positions and other short-term financing needs. While the normalisation of US monetary policy will not be supportive for these markets from a liquidity perspective, the path these currencies take and the differences between them will be determined by their domestic fundamentals and the extent to which they are able to benefit from the broader global economic recovery over the medium term. This could be more difficult for currencies such as the Brazilian real, Chilean peso and Russian ruble which may not benefit from increasing global growth as they remain very sensitive to the commodity cycle.
In the short term, investor sentiment towards emerging market currencies is likely to be driven by geopolitical risks, policy responses in emerging markets and the prospect of further weakness in activity data. Already in 2014 there have been concerns about emerging market contagion following the significant devaluation of the Argentinian peso and the escalation in tensions between the Ukraine and Russia. Meanwhile there are local or national elections scheduled in a number of emerging countries during 2014, including India, Indonesia, South Africa, Brazil and Turkey, which could create political risk and act as a catalyst for higher volatility over the coming months, triggering further outflows from foreign investors.
As a result we believe it is sensible to stay on the sidelines for now, but we expect to turn more positive on high yielding currencies once there is greater clarity on these risks and negative emerging market flows have started to stabilise.