Rising trade tensions with China have dominated headlines and led to heightened volatility for commodities and other risk assets. Yet we believe the case for commodities remains strong against a supportive macro backdrop and tightening physical markets.
The global economy is heating up and inflationary pressures are building, which should place a premium on commodities, historically one of the best asset classes for hedging inflation. More importantly, market forces appear to be aligning on both sides of the supply-demand equation, creating what we believe is a “sweet spot” for the asset class, as our analysis indicates that a majority of commodities are in the tightening phase of the fundamental commodity cycle (see chart below).
Oil supply growth stunted by producer discipline and elevated geopolitical uncertainty
Energy-related capital spending in North America is expected to increase this year, with much of it taking place in US shale. However, global spending should increase only modestly for the remainder of the year. Even with oil prices on the rise, oil and gas companies are more likely to allocate excess cash flow to strengthening their balance sheets and returning cash to shareholders, rather than making significant investments to grow production.
Concurrently, the lack of spare capacity in the global oil supply system, especially within OPEC, should make it difficult to absorb potential supply disruptions from destabilisation in key oil producing regions (Iran, Venezuela, Nigeria, Libya).
The net effect is that we expect the global oil supply/demand balance to remain in deficit over the next three to five quarters, further reducing inventories.
Underinvestment in metals driving long-term deficits
Metals have sold off in the first three quarters of 2018 on fears of substantially lower demand resulting from escalating trade tensions, particularly between the US and China. But so far, we have seen essentially no impact from trade on metals demand, and we expect that above-average global growth will continue to drive stronger demand this year and next—counter to what current base metals prices seem to indicate.
Metals and mining commodities generally remain the furthest along in terms of rebalancing supply and demand. While stronger-than-expected global demand has helped, we believe the more important factor is the prolonged underinvestment in new projects. Despite higher prices over the last two years, most mining companies continue to prioritise shareholder returns through dividends and buybacks over investing in new production.
Over the next year or so, we expect pricing to be driven more by the group’s supportive fundamentals than macro-driven sentiment. Even if prices rally further, it can take years to complete a new mine from scratch—and almost no one is planning new mines right now. That means deficits should persist for the next several years across much of the sector.
Delayed rebalancing in agriculture slowly unfolding
Agriculture commodities, specifically US grains such as corn, soybeans and wheat, have taken longer to rebalance than other commodities due to prolonged oversupply. Yields have been above-trend for years, and coordinated production cuts among the 500 million farms around the world are generally unfeasible, unlike in other commodity markets. This fragmentation typically leads to longer boom-bust cycles, which means tightening of global inventories is likely to remain gradual.
However, we are starting to see stabilisation in global acreage. Adverse weather conditions in South America, the Black Sea region, and Australia have also trimmed output in the recent crop year, driving deficits across much of the grain complex, which may be met with higher prices over time.
We are also monitoring the potential development of an El Niño weather pattern, which many climate models are predicting will emerge in late 2018/early 2019 that would have implications for agriculture crops around the globe.
Conclusion
Commodities have historically outperformed equities towards the end of expansion cycles and in the early stages of recessions. In general, this is because equity valuations are generally forward-looking and tend to contract in anticipation of slower earnings growth.
By contrast, commodity spot prices typically reflect the relative tightness of supply and demand at that moment, when demand growth is usually peaking. While not a predictor of future returns, we believe the evolution of the current business cycle, coupled with tightening supply and demand fundamentals, bodes well for commodities.
Ben Ross, portfolio manager, Cohen & Steers Active Commodities strategy
