Commodities have pulled back considerably over the summer, and at times like this it can be difficult to maintain conviction in the long-term bull market story. In the past few months, we have seen dramatic reversals of sufficient magnitude to tie an investor’s stomach into knots. As experienced investment managers, though, we have lived through this type of market in the past. The experience is painful and has been known to turn a few hairs grey. However, at Castlestone Management we believe now is most certainly not the time to abandon commodities. Commodities, like any market, cannot advance steadily upwards without an occasional correction… even the occasional gutwrenching, multi-month correction.

Economic concerns are currently dominating the markets. The US is mired in the midst of a credit and housing crunch that has yet to find a bottom. Eight months of job losses and a rising unemployment rate have taken a toll on consumer spending. Europe is now in the midst of a similar slowdown and fears of global recession are on the rise. A fear of this economic weakness has pervaded all markets, and asset managers have been aggressively taking risk out of their portfolios.

Commodity prices have finally been overwhelmed by this overall bearish economic picture. Though it has been a tough summer, it is important to remember that the fundamental factors, which make commodities such a compelling investment, are still intact. These factors have temporarily been overwhelmed by the gloom pervading the global economy; given time, the focus will return to these factors, and commodity prices will rebound and continue their long-term climb.

A stronger dollar is also making dollar-denominated commodities more expensive in parts of the developed word. However, a stronger dollar has only a limited effect on diminishing commodity demand, as the drivers of demand growth are primarily the emerging markets. Much of the developing world either pegs their currency to the US or fixes commodity prices to protect the end user.

Industrial metals
Though inventories have been building in industrial metals, the long-term imbalance between supply and demand remains unchanged. Billions of dollars in infrastructure spending is expected in the developing world over the next decade. A temporary economic slowdown does not diminish the need for roads, airports and apartment buildings as populations continue to grow and flock to urban centres. Though demand has slowed in the short-term, supply shortfalls still support the market.

Power supply problems continue to constrain aluminium production, and a copper market still in supply deficit will keep stocks low and hence susceptible to disruption. Base metals tend to wear the pain of recession fears the most strongly, and we have reduced our weightings over the past two months to reflect our concerns. However, these will rebound quickly on any signs of economic strength and we look for value opportunities to increase our exposure.

Precious metals
The ongoing political tension triggered by Russia’s spat with Georgia is adding to demand for safe-haven securities, but even without this, there are many factors supporting precious metals prices. While sharp corrections are painful, no rally takes place without them. The volatility of equity indexes is keeping investors wary of pouring money back into stocks, while ongoing inflation concerns are also supportive. The problems afflicting production in South Africa, the largest producer of gold and platinum, aren’t receding any time soon, keeping the market watchful on supplies in the coming months. With an economic backdrop supportive of demand, and a damaged supply chain, the long-term outlook remains positive.

Periods of market pain such as this force us to reflect on our investment goals. Our goal is the long-term appreciation of capital. Commodities are still in the midst of a long-term rally, caused by growing demand and the inability of supply to keep pace. The rewards of long-term investing, of suffering through the short-term pain, will be forthcoming.

Matthew Sena is a fund manager at Castlestone Management. For more information, contact your local FP adviser