2018 has been an eventful year so far for global markets. When considering the key events of the year, you would be forgiven for focusing on the return of volatility, the impact of a possible trade war or even the repercussions of 10-year US yields topping the 3% mark. A less discussed story has been the resurgence of commodities. To the end of April, wheat, oil (both Brent and the West Texas Intermediate) and corn have all posted double digit returns (in local currency terms). So has this strong start to the year been an anomaly or are the stars beginning to align for the commodities sector?
In our view, much of the renewed interest in commodities can be attributed to the asset class being a late cycle performer, with this cyclicality being driven by the supply/demand dynamic and its connection to the health of the global economy. In simple terms, when the economy is growing, more commodities are used, inventories tighten and prices rise. While the world has benefited from a prolonged period of global growth, the resultant boost to commodities has yet to fully materialise. However, improving fundamentals suggest we are now approaching a sweet spot for commodities that could persist for the next few years.
Unlike most asset classes, commodities are not priced based on discounted future earnings, but are priced based on the current environment. Chart 1 illustrates this evolution, showing how the asset class has moved from being in a state of oversupply in 2015 to a position of deficit in 2018.
Chart 1: Commodity Demand versus Supply
The chart also highlights the regular occurrence of such cycles. These often commence when prices are high, such as in 2008, and companies seek the opportunity to invest – ie energy and mining companies develop new mines/oil wells. Yet, the benefits of such investments are not instantaneous; it can take several years for any new supply to reach markets during which time the overall economic environment can be vastly changed. As an example, when the new supply initiated in the 2008 boom reached markets in 2013/14 the world economy was not as strong, demand was lower and prices declined. Lower prices tend to restrict companies’ investment plans and over time surpluses start to clear, inventories decrease and new deficits start to build.
Aside from a supportive deficit position, we consider commodities to be very attractively priced at present. Chart 2 analyses the ‘all time high’ prices of key commodities compared to those in 2018 and shows that nearly all of them are trading at a discount to their peak of between 30% and 80%. In fact there are only a few instances, such as palladium and lumber, where prices are near their all-time highs.
Chart 2: Current Price versus All Time High
Right now there are some key areas within commodities that stand out to us:
The supply/demand dynamics for industrial metals is undoubtedly attractive at present; our research suggests the market is at its most undersupplied position in 20 years. However, prices have not risen as would be expected, an outcome that we attribute to concerns about Chinese growth expectations. That said, the demand for metals has altered in recent years, reflecting the changes to the technology arena. Further pockets of interest remain within this sector. A key example here is the growing move towards electric cars and the need to develop batteries to support this growth. Lithium and cobalt have been the principle beneficiaries of this demand and supply for these metals is already stretched, with companies seeking out deals directly with suppliers rather than relying on the open market in order to secure supply. Ever resourceful, the industry is looking to incorporate other metals, such as nickel, to help solve the supply constraint.
While renewable energy sources are gaining traction, the demand for traditional energy sources has not abated, with oil prices strengthening further this year. When looking at oil it is important to recognise that this market is heavily manipulated by key suppliers, such as OPEC, who seek to exert control over prices and manage market expectations by issuing forward guidance in the manner of central banks. OPEC’s most recent goal has been to scale inventories back to their five-year average, limiting supply and supporting the move to higher oil prices. This agenda has been strengthened by the recent news that the US is pulling out of the Iran nuclear deal and slower production in Venezuela, suggesting the direction of travel for oil prices is likely to be positive in the near term.
Unlike other commodities sectors, demand for agricultural produce tends to remain broadly stable, although is it subject to longer-term influences such as growing global population and a contraction in agricultural land. This means concerns about the supply pipeline – that generally stem from natural phenomena, such as challenging weather conditions in areas of strong agricultural production – have a much stronger influence on prices. A period of benign weather conditions in recent years has allowed supply to flourish, but recent dry spells have led to specific concerns about soya bean supply in Argentina, cocoa crops in the Ivory Coast and US wheat production, which has positively impacted prices.
While one can clearly make a broad case for commodities being an attractive investment, it is important to note that commodities as an asset class is not homogenous. Correlation between the different sectors can be low as they tend to be driven by different factors. For example, hard commodities are typically driven by macro forces, while soft commodities are less directionally influenced. This means not all commodity types will be in deficit or surplus at the same time, creating alpha generating opportunities for an investment approach that is both active and unconstrained.
Source: GAM unless otherwise stated.