Improving Fundamentals Boost Case For Commodities

By Hakan Kaya

Commodity markets are once again attracting investors.

Unlike recent years, the asset class today is supported by improved fundamentals, as demand growth across the commodity complex is strong and supply is generally short and fragile. Improved performance in 2017 - along with fears of higher inflation and thus a weaker U.S. dollar - drove solid net inflows into commodities, a trend that we believe can continue given the value and diversification potential commodities offer relative to overvalued and recently lower-yielding traditional assets such as stocks and bonds. As you can see in Figure 1, the ratio of the price of the S&P GSCI versus that of the S&P 500 remains well below its long-term median, which combined with encouraging fundamentals could represent an attractive entry point for commodities.

In this short paper, we analyze the recent alignment of demand and supply that explain the re-emergence of commodities as a key component in diversified portfolios from a return, risk and inflation-hedging perspective.

Figure 1. Commodities Look Attractive at Current Levels

S&P GSCI versus the S&P 500 Index

Source: Bloomberg.

Synchronized Global Growth Drives an Acceleration in Commodity Demand…

Commodity demand and global economic growth generally go hand in hand. As output gaps close globally and economies start to operate over capacity, we tend to see excess demand for commodities, boosting their performance, as shown in Figure 2. Recent economic data appear to support this observation, and we are seeing expansion in nearly all the world's economies (see Figure 3) and healthy PMIs in all key import and export regions for the first time since 2014. Given the broad connectivity of the global economy, this synchronized emergence of the late stage of the business cycle should be a tailwind for commodities, one we have not experienced for more than a decade. It is often in this phase of the business cycle that we see improved demand for commodities followed by cost inflation that hurts stocks and bonds in terms of margin squeezes or coupon devaluation, respectively.

Figure 2. Commodities Historically Have Tended to Outperform in the Late Stages of the Business Cycle

Asset Returns across Business Cycles, 1951 to Present

Source: Ibbotson, Bloomberg, Datastream, National Bureau of Economic Research. Note: Stock = Ibbotson Large Company Stock Index; Bond = 20-Year U.S. Treasury Bond; Commodity = S&P GSCI (January 1970 to present), CRB Commodity Index (pre-January 1970).

Figure 3. Nearly All the World's Economies Are Currently Expanding

Measured by Purchasing Managers' Index (PMI)

Source: Bloomberg. The Purchasing Managers' Index (PMI) is an indicator of the economic health of the manufacturing sector. PMI greater than 50 signals an expanding economy.

…While a Rebalanced Supply Side Provides Support

Perhaps more interesting than the demand dynamics is the supply side of the equation, which points to shortages in many key commodity markets. Behind these shortages is the common thread of supply discipline driven by low prices. High commodity prices in the 2000s incentivized producers to invest in capex, look for new technologies and increase productivity. These long-term projects came to fruition in 2010-2015, driving the shale boom in energy, more efficient mining in metals and better adverse climate-resistant seeds in agriculture - along with commodity supply abundance and ultra-low prices.

Many naively expected that rational producers would cut production to support prices in such an environment. This didn't happen; in fact, producers across the commodity complex increased production even further. There were a few reasons for this: 1) producers were aggressively pursuing market share; 2) the strength of the U.S. dollar overshadowed local-currency wages and other costs; and 3) every producer seemed to expect others to cut production first, resulting in an impasse. An event in late 2015 broke this equilibrium, however: the long-awaited launch of the Federal Reserve's rate-hike cycle.

Contrary to popular belief, Fed tightening was quite helpful in bringing supply discipline back to the commodity markets. Credit-related problems began to emerge across the commodity complex in the months following the initial hikes, leading to increased M&A activity, mine closures, difficulties financing new projects, disinvestment in agricultural machinery and more. In sum, rate hikes changed producer behavior, incentivizing them to reduce or delay production, and the implications of this tectonic shift are still being felt in the commodity markets.

Idiosyncrasies Are Inevitable

Idiosyncratic events in recent years - the Indonesian ban on nickel exports, the oil rally starting in 2016, the jump in hog prices due to the PEV virus, to name but a few - reminded us about the fragility of supply chains that resulted from these new supply constraints. These cases made it evident that prices can jump quickly when demand is healthy and when supply is less readily available.

Going forward, these kinds of idiosyncratic events, of course, will continue to occur, though their impact on commodity prices may be greater compared to the past decade assuming demand growth remains robust. Given healthy demand growth and questionable-at-best supply growth, idiosyncratic events such as strikes in mine-exporting countries, oil production setbacks, natural disasters, new viruses or pests, and geopolitical tensions near major supply routes may have significant impacts on prices.

Investment Demand for Commodities Has Picked Up

A few trends have emerged in terms of the investment demand for commodities. First and foremost, the attractive performance by commodities over the past few years has inspired investor inflows, as it tends to across asset classes. This is likely to persist as long as performance remains attractive.

Second, a regime of positive roll yield has emerged as inventories have fallen over the last few years. Today, many key commodity markets are in backwardation - meaning that spot prices in a market are higher than prices for futures contracts. In such an environment, even if spot prices do not move, an investor can create a carry yield just by rolling futures contracts as they mature; this is sometimes referred to as the "coupon payment" or the "roll yield" of commodities. As shown in Figure 4, the roll yields on the S&P GSCI and Bloomberg Commodity Index are now positive and high enough to capture the attention of yield-chasing investors.

Figure 4. The Roll Yield of Commodities Turned Positive

Weighted Average Backwardation

Source: Bloomberg, Neuberger Berman. Note: The latest weights of S&P GSCI and Bloomberg Commodity indexes are used to take the weighted average of the backwardation levels of commodities at each date.

Third, a typical investor today faces a perhaps unprecedented asset allocation problem in that equities, government bonds and credit securities are all quite expensive at the same time. Meanwhile, forward-looking return estimates for these investments are muted and negatively skewed. In this environment, we can expect investors to search for assets that are cheap and that can hold their value until the traditional markets become fundamentally attractive again. With low correlations to stocks and bonds (see Figure 5), non-threatening volatility levels and the potential for a significant upward reversion, commodities fit the bill as an attractive alternative in the current environment.

Figure 5. Diversified Commodities Have Exhibited Low Correlation to Stocks and Bonds

Rolling One-Year Correlation

Source: Bloomberg, Neuberger Berman. Note: Correlation is calculated by taking the rolling 252 business day correlation of the daily returns of S&P GSCI and Bloomberg Commodity Total Return Indexes against the S&P 500 Total Return Index and Bloomberg Barclays U.S. Treasury Total Return Unhedged USD Index.

Finally, also brewing in the markets is the idea that long-term inflation drivers will finally show some life. While they have not been a major threat in the past few decades, wage growth, rent growth, education and healthcare costs are expected to settle on an upward trend thanks to remarkably low unemployment rates. Signs of an uptick in inflation expectations can be seen in Figure 6, which depicts the five-year breakeven inflation rate. Should inflation expectations settle into a higher range as global central banks continue to manage the delicate retreat from extraordinarily accommodative policy, there is a nonzero possibility that a potential central bank policy error could create a feedback loop that results in hyperinflation. Investors eventually will look for natural hedges as concerns about inflation shocks grow, and commodities likely will see an uptick in demand as a result.

Figure 6. Inflation Expectations Are Rising

Five-Year Breakeven Inflation Rate

Source: Federal Reserve Bank of St. Louis.

Conclusion

In terms of both supply and demand fundamentals, commodities markets today are in better shape than they have been at any point in the past decade. The asset class offers investors attractive relative valuations, positive dividend-like roll yield and momentum, while maintaining its traditional role as an inflation hedge and a source of low to negative correlations to richly valued equities and low-yielding bonds. Because of these factors we have started seeing renewed interest in commodities, and we expect this trend is likely to intensify over the coming months absent any significant demand shocks such as a recession.

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This material may include estimates, outlooks, projections and other "forward-looking statements." Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed.

Investment exposure to the commodities markets and/or a particular sector of the commodities markets, may subject an investor to greater volatility than investments in traditional securities. The commodities markets are impacted by a variety of factors, including changes in overall market movements, resource availability, commodity price volatility, speculation in the commodities markets, domestic and foreign political and economic events and policies, war, acts of terrorism, changes in domestic or foreign interest rates and/or investor expectations concerning interest rates, domestic and foreign inflation rates and investment and trading activities in commodities. Prices of various commodities may also be affected by factors such as drought, floods, weather, livestock disease, embargoes, tariffs and other regulatory developments. The prices of commodities can also fluctuate widely due to supply and demand disruptions in major producing or consuming regions. No active trading market may exist for certain commodities investments.

The S&P GSCI® Index is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. The combination of these attributes provides investors with a representative and realistic picture of realizable returns attainable in the commodities markets.

The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index (stock price times number of shares outstanding), with each stock's weight in the Index proportionate to its market value. The "500" is one of the most widely used benchmarks of U.S. equity performance. As of September 16, 2005, S&P switched to a float-adjusted format, which weights only those shares that are available to investors, not all of a company's outstanding shares. The value of the index now reflects the value available in the public markets. Please note that indices do not take into account any fees and expenses of investing in the individual securities that they track, and that individuals cannot invest directly in any index.

The Ibbotson Large Company Stock Index is represented by the S&P 500 Composite Index (S&P 500) from 1957 to present, and the S&P 90 from 1926 to 1956.

The CRB Commodity Index is an arithmetic average of commodity futures prices with monthly rebalancing.

The Bloomberg Commodity Index is calculated on an excess return basis and reflects commodity futures price movements. The index rebalances annually weighted 2/3 by trading volume and 1/3 by world production and weight-caps are applied at the commodity, sector and group level for diversification.

The Bloomberg Barclays U.S. Treasury Total Return Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index.

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