It has been well-publicised that commodities, as a broad asset class, have provided superior returns for investors over the last year when compared to the likes of equities or fixed interest. This has been caused by supply chain disruptions in the wake of Covid and the conflict in Ukraine, which has inflated the price of energy and boosted indices.
The broad index is up more than 13% year-to-date, and at a point in early June had added nearly 38% since the beginning of the year. This is in no small part due to a natural gas price that has surged 76% this year, and an oil price that at its 2022 peak had added more than 64%.
Despite these soaring headline prices, the index has sold off considerably since early June and we have seen the oil price move into negative territory for the year as recession has been priced in and a risk-off gold trade has moved the price of the precious metal to $1,782, up 9.1% since the start of November.
With prices falling away, the question raised is whether or not commodities have a place in investment portfolios going forward, or have we seen the upside run its course as demand falls through a recessionary 2023.
A key consideration when thinking about commodities is the part that prices play in inflation. If it costs more to make and move things, those higher prices feed into headline inflation numbers. It has predominantly been high inflation that has been informing central banking policy over the last year. Interest rates have been raised with the intention to lower prices, which has seen commodities come down over the last six months.
Moving through into 2023, it is widely felt that we will see interest rates peak in developed economies in the first half of the year. This has at times led to positive sentiment from investors that perhaps recession will be delayed or softened, and that the consumer may well hang on. Time will tell on how fiscal policy feeds into headline economic indicators.
From a commodity standpoint it is not as simple as saying the cycle is finished. The energy crisis is not disappearing overnight, though this will ease as warmer weather approaches next Spring. We have also seen a resurgence in positive sentiment towards Chinese assets as the country has looked to loosen its zero-Covid policy. If Chinese production and growth picks up, in a region not plagued by the inflationary woes felt by its developed peers, global demand will rise. This is to some extent dependent upon the US avoiding a deep recession, as the two economies are inextricably linked.
It is often the case an overheated commodity cycle (such as we have seen this year) is set to cool in a recessionary environment. Depressed growth can leave prices to settle lower, though this is said with an element of caution. The price of commodities in a fundamental sense is not set just by demand but also supply, and there are question marks here.
Whilst it is true there may be a widespread fall in demand for industrial commodities, the space is still facing supply-side challenges. Schroders have recently commented on the fact that capital expenditure is down, creating underinvestment in commodity production. This, they argue, will lead to continued supply constraints that will highlight any demand shocks.
If we see softer central banking policy support the demand side or even avoid recession, pricing in the commodity markets may well move higher, notwithstanding recent falls in the index. A softer slowdown would provide future support for the likes of oil, particularly with a resurgent China, and a protracted tightening cycle. In this state we would expect high growth companies to remain under pressure as the economic environment remains challenging and cost of capital high, with commodities acting as a hedge in the short term.
We made an allocation to commodities for the first time back in 2021 when we could see returning demand outstripping supply after the pandemic, driving prices higher as economies reopened. This proved to be a sensible allocation and portfolios have benefited from this diversification, especially through the first half of 2022. Our allocation is up 12% year-to-date and has not been skewed by a strong US dollar, as we hedge out this currency impact.
We will continue to monitor the global outlook for commodities and act when we feel the diversification benefit of this exposure falls short of the return profile in the prevailing environment.
Source: Refinitiv – Market returns 09/12/2022 to 15/12/2022