It is time for investors to start considering the risks posed by El Niño to commodity ETFs and allocations across portfolios as the Climate Prediction Centre predicts a 95% chance the climate pattern will take effect during the winter months.
Caused by above-average surface water temperatures in the Pacific Ocean, El Niño is characterised by suppressed rainfall across southeast Asia from December to February and warm and dry weather across much of Latin America from June to August.
While its impacts are not entirely consistent over time, acute supply shocks in agricultural commodities have been attributed to the climate event including the 50% collapse in Australian wheat yields in 1994.
Recent El Niño episodes also pushed global yields of rice down by 1.3%, corn by 0.3% and wheat by 4%, according to data from Nature Communications.
Rice prices also hit a near 15-year high in August amid fears El Niño-related dryness would hamper yields in Thailand, the world’s second-largest exporter, according to Bloomberg.
Discussing the climate pattern as a risk management consideration, John Leiper, CIO at Titan Asset Management, said: “It is definitely something we have on our radar, it is definitely a theme that we like and definitely one that is under-represented as a key risk factored in by asset managers.”
Leiper added his team have been monitoring “a number of ETFs” that might be used to address the theme including the WisdomTree Agriculture ETC (AIGA).
However, he noted the impact of El Niño across agricultural commodities is not consistent and therefore broad basket approaches such as AIGA have struggled to break out from broad market indices such as the MSCI World in recent months.
Interestingly, some investors have looked to remove their exposure to agriculture altogether in recent months, with the Amundi Bloomberg Equal-Weight Commodity Ex-Agriculture UCITS ETF (CRB) booking $345m inflows in the month to 25 August, the highest of any Europe-listed commodity product.
This approach has been vindicated over recent months, with AIGA returning -3.5% over the past three months, as at 3 October. Meanwhile, its agriculture-shy equivalent, the WisdomTree Enhanced Commodity ex-Agriculture UCITS ETF (WXAG) booked 5.3% gains over the same period.
However, this has not stopped some more dynamic commodity strategies adding to their allocations in individual agricultural commodities.
Legal & General Investment Management (LGIM) told ETF Stream its L&G Multi Strategy Enhanced Commodities UCITS ETF (ENCO) – whose underlying Barclays Backwardation Tilt Mult-Strategy Capped index looks to capture commodity price seasonality and futures contract roll and collateral return – currently overweights sugar.
“The Barclays index will overweight those 10 commodities on a monthly basis that exhibit the highest level of backwardation – or least contango. Sugar, for example, has a higher weight in ENCO versus in the Bloomberg Commodity index, as of the beginning of October 2023,” LGIM said.
Far-reaching economic effects
However, potential impacts and necessary considerations regarding El Niño and lower crop yields could also have far-reaching effects for emerging markets and global supply chains.
On the former, Leiper noted agriculture-based components comprise between 45-50% of the CPI baskets of some emerging markets including India, meaning hampered crop yields could pose material risks to these country’s inflation reduction efforts.
“Over the course of the year, many emerging markets have done well getting ahead of the curve on inflation relative to developed markets,” he continued. “If the El Niño theme were to play out, in conjunction with energy price increases, some might struggle after making progress and bringing rates down.
“There is now a requirement to look at real yields on emerging markets and seeing which of those have seen their yields fall the most over the course of the year because they could be most vulnerable.”
A recent report by MSCI Research senior associates Alexander Schober and Cole Martin highlighted El Niño could start a “cascading trend” in food prices already elevated by COVID-19 and the Russia-Ukraine war, prompting governments to step in.
This combination of lower economic growth and higher fiscal expenditure, it warned, could prompt higher debt-to-GDP in the year following the El Niño event. In fact, median debt-to-GDP increased 2.1% in emerging markets for the years following an El Niño event between 1994 and 2021 – though MSCI noted this coincided with the Asian financial crisis and the COVID-19 pandemic.
“Sovereign-debt investors may wish to bear El Niño in mind when making country-allocation decisions,” MSCI said. “The magnitude and nature of the impact can vary substantially between countries and even within countries.”
Leiper added the climate event also creates the risk of “tangential impacts” on supply chains such as a drop-off in water levels in inland shipping routes – including the Suez Canal – during the initial onset of El Niño.
“In this way, it ends up having an effect on the amount of cargo ships can carry and the frequency with which ships can pass through,” he said.
MSCI agreed the climate event could hit global productivity and “ratchet up” capital expenditure in some countries where the most acute impacts damage infrastructure.
“Some areas, such as Peru and southeast Asia, have already begun to prepare for El Niño,” it concluded.
Overall, agricultural commodities remain the focus for investors looking to risk manage their exposure to upcoming climate events, however, those not paying attention may still feel the impacts in the segments of their portfolios exposed to emerging markets, shipping, manufacturing and infrastructure.
