Outlook 2018: Commodities
With global inflation forecast to pick up, is it time to add exposure to commodities, where fundamentals are improving and valuations are attractive?
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We believe that the recovery in commodity prices that started in early 2016 and paused in 2017 is likely to continue in 2018. Underlying supply and demand balances are increasingly positive in key energy, metals and select agricultural markets. Importantly, the structural outlook for the dollar looks increasingly weak, while global inflation has likely bottomed.
Time for inflation-friendly asset classes
Commodities remain firmly stuck in “out of fashion” in the sentiment cycle, characterised by underweight investor positioning and fund closures. Few investors have any proper inflation hedge in their portfolios. With the improved market outlook outlined below, it is in our view time to reassess exposure to such inflation-friendly asset classes as commodities.
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Inflation itself has likely bottomed. Global debt burdens remain high and global growth remains highly sensitive to any real increases in interest servicing cost. As a result, developed market central banks will likely be very wary of raising interest rates too quickly, and may let economies run hot. Real interest rates, a key driver of gold prices for example, should continue to remain very low and possibly negative as inflation accelerates in 2018. In the medium-term we fully expect governments and central banks to move towards more explicit fiscal “print and spend” policies (“people’s quantitative easing” type policies) in a bid to increase growth and appease disaffected populations. Such a shift, if combined with more friction in global trade, would be tremendously inflationary.
US dollar depreciation set to continue
A strong US dollar was a big negative for commodities through the bear market which ended in early 2016. 2017 dollar depreciation likely marks the start of a new dollar bear market. What could drive this? Several factors. An increase in the US’ domestic budget and foreign trade deficits, driven by tax cuts and high military and entitlement spending, which historically correspond reasonably well with periods of dollar weakness. Further political dysfunction or even questions concerning the serviceability of the US debt burden are also on the horizon. A weak US dollar in 2018 will likely provide overall support for the commodities asset class.
Past performance is not a guide to future performance and may not be repeated.
Oil and energy
For oil, and energy in general, the outlook has already improved markedly. Perhaps more importantly, the key risks for crude prices now appear skewed heavily to the upside. On the supply side, production continues to underperform expectations in a number of countries - for the first time in a number of years. Meanwhile on the demand side, global consumption is impressively strong. As a result, crude oil inventories should decline sharply as we move in to 2018.
The outlook for US natural gas prices from current levels remains bullish for 2018, and not simply due to structural growth in demand. This important commodity is much unloved by investors, given poor historical performance and its high volatility. The consensus view is that current low US gas prices are the new normal and it will stay at this level for the next few years. Assuming typical winter temperatures hit the US over the next few months, we estimate that the US gas market is undersupplied and that prices will need to go higher in order to prompt a production response. This undersupply is being driven by increasing dry gas exports to Mexico, coupled with a further 1 billion cubic feet per day of liquefied natural gas export capacity starting up in late December.
Fundamentals also remain supportive for a number of key agricultural markets in 2018. The wheat markets look to have formed a significant bottom and many soft commodity prices are likely to be supported by long-term structural demand growth. This is in addition to supply vulnerabilities due to poor weather conditions and falling yields.
We remain positive for 2018 on base metals where potential supply impacts are greatest: aluminium for example is likely to see a major downshift in supply growth rates. Nickel has also likely reached a bullish long-term inflection point. Conversely, copper and iron ore are the most exposed to potential demand slowdowns next year.
Should global equity euphoria weaken in 2018, gold could stand to benefit significantly. Global equity markets have now added close to $9.5 trillion in market capitalisation over the course of 2018 and valuations are very high. Against a backdrop of increasing geopolitical and financial market volatility, gold and silver’s solid track records as liquid and easily transferable tangible assets that have long been considered as a currency of last resort, may come increasingly onto investors' radars. Despite having made solid returns in 2016 and 2017, both remain soundly unloved and under-owned.
Over the long term, from current low valuations, gold equities are expected to outperform the underlying metal as prices rise. The current weighting of North American gold equities in the S&P500 and TSX Index has fallen to just 0.6% after reaching a peak of over 2% in 2012. To put this low weighting into perspective, the entire North American gold producers have a combined market capitalisation of less than $150 billion. This highlights the scarcity value of gold equities if a bull market in gold gathers momentum. Essentially, this extremely low weighting reflects investors' current low positioning around gold and gold equities, as well as the very high valuations of other more mainstream sub-sectors.
Commodity fundamentals improving and valuations attractive
Despite improving commodity fundamentals driving prices higher, energy equities have mostly underperformed the underlying commodities in 2017. This is primarily because equity investors aren’t using the equities solely as a directional commodity bet like they have done in past cycles. Disappointments on subpar/negative returns being amassed, and the continued destruction of capital, have led to commodity equities being heavily avoided. Investors await a time when commodity related, and particularly energy, companies demonstrate suitable rates of return on capital and consistent free cash generation. Once investors are confident the obsession with “growth” has been consigned to the past, we should see capital returning to the sector.
Overall, commodity equity valuations have rarely looked so cheap relative to the broader market and relative to underlying prices. Many companies, most notably in the energy and precious metals spaces, should now prove to be more investable in 2018. This is due to their recent focus on free cash generation, further balance sheet strengthening, returns on capital and increasing shareholder distributions. This appealing mix of recovering commodity prices and cheap valuations is likely to provide investors with an excellent opportunity to diversify risk and seek protection from rising inflation.