Explaining Recent Commodity Performance

by: Paul Ticu

Summary

Explaining recent commodity performance.

Commodities don't have an encouraging fundamental picture at this stage.

The run-up is likely due to overvaluation in other asset classes and could be short-lived.

Year to date, commodities have been one of the best performing asset classes, with the DJ UBS returning - at the date of this writing - in excess of 6%. Although there have been a couple of US equity sectors with comparable performance (e.g. Utilities, Real Estate), overall the S&P 500 is still dealing with the after-effects of last year's increase. Other asset classes have returned less, with emerging market equities at the bottom of the list. The obvious question is why commodities should outperform and why now.

It is true, commodities did not participate in the liquidity driven rally of the past years and this could be the catch-up trade. Another reason could be that commodities are a good diversifier, although this was not really true in the recent years due to high correlations. Commodities hedge against geopolitical risk, and there is the Ukraine / Crimea situation, but other risk assets have not corrected. Inflation is too weak at this point to support the typical inflation-hedge argument.

Commodities have a firm anchor in the real economy and supply/demand does affect price action. From a fundamental angle, the ideal combination for a bullish investor is that of insufficient production, combined with low stocks. Unfortunately, most commodities are not in this situation. Most are still in surplus, while worldwide demand will be below average this year: US average growth since 1970 is 3.2% and this would be a good print if realized this year. Nevertheless, most of the global growth in 2014 will not come from the US or Europe, but emerging markets where valuations happen to be fairly low.

On the energy side, the crude complex is range-bound; there is sufficient supply and the global demand picture is lukewarm at best. Industrial metals are in oversupply as miners have taken advantage of the easy capital over the past years and added capacity. Copper is particularly vulnerable although it is trading too close to its cost of production to short here. China, a key consumer of industrial metals - approximately 40% of copper - is rebalancing its economy slowly away from Fixed Asset Investments towards consumption, and targeting a lower growth rate. Lastly, agricultural products will be a weather bet, but after the price action in grains in 2011 and 2012, acreage will be plenty, and if the weather is "normal", production will be high enough to meet demand.

Looking forward over the next 6-12 months, it is evident that the dollar is quite low and the EUR too high. If this situation persists, the ECB will finally do something and the dollar will strengthen, which will not help commodity prices.

The only explanation that makes sense is that commodities are undervalued relative to other asset classes. The problem with this argument is that commodities have been undervalued with respect to other asset classes for years. The difference now could be that after 2 very good years in US equities, earnings growth - even if 2014 turns out to be a decent year - is unlikely to catch up. Last year was driven mostly by multiple expansion which is approaching its limits. It is also certain that interest rates will go higher; it is just a question of timing and which path these will take.

In conclusion, it appears that the recent run-up in commodity prices is mostly driven by concerns about valuation levels in other asset classes and not because commodities are particularly desirable at this point as a stand-alone investment or from a portfolio perspective (correlations may come down at some point, but it is not happening yet). If this reasoning holds, then the current performance spike in commodities could be fairly short-lived.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.