Is the commodities rally built to last?

Multi-Asset Strategist Adam Berger and Commodities Portfolio Manager David Chang discuss the recent strong performance of commodities amid rising inflation and the decision many investors face about whether to initiate or add to allocations in the asset class.

Adam: Commodities were the only major asset class that performed well through the first half of 2022, and it wasn’t close (Figure 1). This came after a long period of underperformance that led investors to pull back on their commodities exposure. The question many have now is whether it is too late to add to commodities. What’s your view?

David: I don’t believe it’s too late and let me explain why from both a cyclical and a structural perspective.

Cyclically, we continue to see commodity inventories unable to keep up with demand, leaving them at extremely low levels across all the major sectors (Figure 2). Oil and aluminum, in fact, are at the lowest levels in the last 30 years when adjusted for demand.¹  This is also driving a substantial change in commodity roll yields, as the roll yield reflects the cost of storage and inventory levels. After a decade of persistently negative roll yields, the futures curves of most commodities have shifted into backwardation. As of the end of June 2022, the asset class was generating a positive implied roll yield of nearly 10%, based on the Bloomberg Commodity Index. With this roll yield, commodities investors are able to be more patient, as they are no longer required to pay a cost to maintain exposure.

Turning to the structural outlook for commodities, I see three key supports for the asset class over the next decade or so:

• First, underinvestment is restricting supply. We have seen years of underinvestment in metals and energy, among other commodities sectors, and yet producers continue to be extremely disciplined about not ramping up their spending — even in the face of high prices and attractive margins.
• Second, decarbonization should be a strong driver of commodities, rather than a negative as might be expected. It will result in higher commodity prices and further restrict supplies. It will also spur demand for commodities used in the transition to renewable energy sources.
• And third, the deglobalization of supply chains will be highly inflationary for commodities. Localizing supply chains will mean duplicating sources of commodity supply in parts of the world where the process is much less efficient.

Adam: How do you expect commodities to fare in the event of a recession?

David: Let me first address the possibility that commodities could actually help bring about a recession. When supply is this inelastic, prices really need to rise to ration and destroy demand, and at a certain point that can cause recession. I don’t think prices are at that level yet, but it is a possibility.

In terms of what a recession could mean for commodities, I would note that the asset class has tended to do well late cycle and early recession, often because prices are rising at that point as the demand destruction that I described begins to set in. That’s a key reason that commodities can potentially be so diversifying versus stocks and bonds. I would also note that not every commodity performs the same in a downturn. For example, precious metals tend to do well as investors seek a safe haven, while energy and industrial metals typically struggle the most.

That said, I am of the strong belief that the impact of a recession on energy and industrial metals would be more muted today than what we saw during the global financial crisis or the depths of the pandemic in 2020. I think the recession in 1973 – 1974 provides a better comparison. There were major supply constraints, yet the downturn had a more limited effect on commodities because there weren’t broader structural issues that needed to be solved. That’s the example that I have in mind today when I hear  from commodity producers that recession fears are constraining their willingness to deploy capital.

Adam: What would you say to investors who may be skittish about adding commodities — perhaps because they were disappointed by results in the past?

David: It’s an understandable point, as a commodity allocation would have been a drag on a traditional stock/bond mix in recent years. But I think it’s important to consider the broader macro shift that appears to be taking place, from a long period of low inflation to an environment that is more supportive of commodities, with higher inflation that I believe is likely to be structural rather than transitory.

At a micro level, I would also note the significance of the shale oil boom, which was deflationary not only for energy prices but for all commodities. And despite the rise in energy prices today, we’re not seeing a supply response from shale producers. That means demand will have to be met by higher cost sources of energy production, and to me that rising cost structure is the key to creating a durable bull market in the asset class.

Lastly, as I noted earlier, the improvement in the commodity roll yield is a big change from the past decade, and I believe it should last for some time, given how low inventories are.

What to do now?

Adam: I’ll close by sharing a few of my own thoughts on inflation and commodity allocations:

Upside inflation risk supports a commodities allocation in a diversified portfolio. I think we could easily be looking at inflation of 2% – 3% over the next five to ten years, which would be a meaningful increase from prevailing rates of the past decade.

Investors may opt for a strategic allocation or a more dynamic approach. The diversifying properties of commodities may justify a strategic allocation for many investors, but I also think it is worth considering a more dynamic approach. As David noted, roll yield is an important sign of the return commodities are likely to provide. It is also a very visible metric and therefore an example of an indicator that could potentially be used to make more tactical decisions with respect to a commodities allocation.

Risk management is critical. From a governance standpoint, commodities are not as intuitive an allocation choice as stocks or bonds, and they tend to be significantly more volatile than either. That makes portfolio decisions, including how to size the allocation, all the more important.

In terms of implementation, I think this is a moment to consider funding or increasing a direct commodity allocation. If that’s not feasible, investors might look to diversified real asset strategies that include commodities in the mix and give the manager the flexibility to lean into or out of the asset class. Finally, commodity-sensitive equities offer another way to play the space, though it may be less diversifying over time than pure commodity exposure.

¹Source: International Energy Agency, London Metal Exchange, as of 30 June 2022.