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Signs Point To Stronger Commodity Prices In 2020

by: Clif Droke
Clif Droke
Long only, momentum, newsletter provider, ETF investing

Commodity investors' patience will be rewarded in 2020.

A rebound in China's industrial demand will push resource prices higher.

Also boosting commodities will be a weaker U.S. dollar index.

The past year has been one that many commodity investors would like to forget. The optimism of those who have a long-term bullish outlook for natural resources was largely disappointed in the year to date. There are, however, several indications that the coming year will be far more rewarding for the commodity bulls. Among the reasons for this sanguine outlook are the likelihood of a weaker dollar in 2020, stronger demand for energy products, and a pickup in industrial activity among emerging nations due to relaxed trade-related tensions. We'll discuss each of these factors in this report.

Don't look now, but commodities are quietly clawing their way back from the low prices that were seen this summer. Thanks in part to a pullback in the U.S. dollar index and an improvement in trade negotiations between the U.S. and China, several key commodity futures have rebounded since hitting bottom in August. Among them are agricultural commodities like wheat and soybeans, lumber, and natural gas. By far the most economically significant commodity is crude oil, which is also showing signs of strengthening.

It's admittedly difficult to discern a turnaround underway in the benchmark GSCI Commodity Index when viewing it from the perspective of the past year. But if you look closely at the last few months, you can see a decidedly rounded appearance in the graph of the GSCI tracking fund, the iShares S&P GSCI Commodity-Indexed Trust (GSG). The recent improvement in this ETF is a combination of the bullish reversals in the aforementioned commodities, including the economically sensitive energy sector.

iShares S&P GSCI Commodity-Index Trust

Source: BigCharts

Speaking of the energy sector, one of the most encouraging signs of the last few weeks from a commodity bull's perspective has been the notable improvement in natural gas prices. Natural gas futures prices have moved explosively higher at times since hitting bottom this summer. While there is a both a seasonal and weather-related element to this strong performance, the duration and magnitude of the upward trend in gas prices can also be considered as a leading indicator for crude oil. Many a natural gas rally has served as a precursor for higher oil prices. And more than perhaps any single factor, a strong crude oil market outlook is needed to convince institutional investors (whose collective buying is needed to sustain a rebound) that the resource market has truly turned a corner.

Natural Gas Continuous Contract

Source: BigCharts

Another reason why the natural gas price rally offers a reason to hope for the intermediate-term (3-6 month) broad commodity market outlook is China. According to an April 2019 report, China will soon eclipse Japan as the world's largest importer of liquified natural gas (LNG). Much of China's industrial production is powered by natural gas, and sustained upward moves in gas prices typically reflect, to some degree, the level of demand from China. Thus, when China's industrial outlook is strong, investors can be reasonably sure that the demand for LNG will be commensurately strong.

Another sign that China's industrial usage of commodities is likely to increase in the coming months is that country's equity market, which discounts improvements to the business outlook. China's stock market has shown some very encouraging signs that it wants to go higher. This can be taken as a sign that investors have already discounted the trade war and are looking forward to better times ahead for China's economy in 2020. Below is the iShares China Large-Cap ETF (FXI), which has established a pattern of ascending highs and lows in the last three months.

iShares China Large-Cap ETF

Source: BigCharts

Moreover, by transposing a graph of the GSCI Commodity Index ETF on top of the FXI graph, you can see the tendency in recent years for China's stock market to predict the overall level of commodity prices by a few months in advance. Thus, an improvement to China's equity market will almost certainly bode well for the commodity price outlook in the months ahead.

iShares China Large-Cap ETF vs. iShares S&P GSCI Commodity-Indexed Trust

Source: BigCharts

China's manufacturing sector has shown definite signs of recovery in the last few months. For instance, the latest Caixin China manufacturing index posted its highest reading last month since February 2017. Higher levels in this survey of manufacturing activity for China also tend to coincide with rising commodity prices. Meanwhile, while the overall level of manufacturing for the U.S. has been declining, it should be noted that the U.S. manufacturing sector is far less important when it comes to determining natural resource prices due to the lesser importance of the U.S. domestic industry compared to emerging nations like China. A continued rise in the Caixin index, however, would be most welcome by long-term commodity bulls.

Caixin China Manufacturing Index vs. U.S. ISM Manufacturing Index

Source: Axios

A final, but equally important factor, in our analysis of the commodity market outlook is the U.S. dollar index (DXY). Since commodities are priced in dollars, a weaker dollar typically exerts a lifting effect on resource prices. This especially holds true for the most inflation-sensitive of commodities like crude oil and the metals. With the dollar expected by many currency experts to return to a lower level in the coming months, commodities should accordingly benefit from this. The dollar was abnormally strong for most of 2019 due to the urgency of demand for safe havens among investors who feared a global recession in the wake of the U.S.-China tariff dispute. But with a final trade deal in sight, investors will have less reason for remaining in the relative safety of the U.S. currency. Participants should expect to see a gradual exodus from the dollar and an increased interest in risk assets among investors, including commodities. A weaker dollar would definitely increase raw material demand in 2020.

With a growing number of factors are converging in favor of higher commodity prices, investors should be more optimistic of the resource sector as we head closer to 2020. In particular, energy-related resources like natural gas will continue to benefit from growing industrial demand from countries like China as trade war fears diminish. A lower dollar index level will also benefit most commodities in the coming months, as will the increase in appetite for riskier assets that always accompanies a weaker U.S. currency. In view of these positive variables, investors are justified in embracing a bullish intermediate-term posture toward the natural resource broad market as reflected by the GSCI Commodity Index.

Disclosure: I am/we are long DBC. 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.