Commodities have broadly pulled back from their recent peaks, but Wall Street analysts say the fundamentals are pointing to another rally by year-end.
As of Friday, the UBS CMCI (Constant Maturity Commodity Index) had fallen by around 11% from its peak in early June, while performance in July was flat, but was still up 16% year-to-date.
In a research note Friday, UBS Global Wealth Management strategists said the supply-side constraints that underpinned the surge in commodity prices in the first half of the year had taken a backseat to the deteriorating outlook for global economic growth, a strengthening U.S. dollar and China’s housing predicament.
Although commodity prices could fall further in the event of a deep recession for the global economy, UBS GWM Chief Investment Officer Mark Haefele and his team suggested a “soft landing” is now as likely as a pronounced slowdown.
They added that “overly bearish calls on commodity markets do not fully account for supply-side dynamics.”
“In general, commodity supply is constrained due to years of underinvestment — official inventories are low across multiple sectors — and because of weather-related and geopolitical factors. Meanwhile, we see positive demand trends,” Haefele said.
For instance, UBS expects Chinese demand to rebound, with manufacturing and property data indicating that more fiscal stimulus is required. While acknowledging that a policy “bazooka” is unlikely, Haefele suggested more support will be forthcoming from Beijing in the months ahead, which should stabilize demand for commodities such as iron ore and industrial metals.
The bank’s strategists also see talk of a U.S. recession as premature, and felt vindicated by the bumper nonfarm payrolls report published earlier this month.
The U.S. economy added 528,000 jobs in July, well ahead of consensus forecasts, while consumer price inflation slowed, indicating that the Federal Reserve may not have to tighten monetary policy as aggressively as previously expected.
“While growth is slowing, the U.S. economy is also returning to pre-pandemic patterns and
in doing so is experiencing a divergence between goods and services,” Haefele said.
“As manufacturing slows, services are growing. While diverging, the data reflect the normalization of goods and services activity.”
Thirdly, UBS pointed to a likely return of fears about supply shortfalls, with industrial metals and steel at the heart of the new commodity cycle and necessary components in the decarbonization process, rendering them central to the price recovery.
“While this narrative is not new, we believe the world is still not prepared for the transition-related surge in demand; and despite higher prices, a decade of poor returns and environmental, social, and governance (ESG) concerns have curtailed investment in the future supply growth of key metals like copper,” Haefele said.
“That means output will struggle to keep pace with rising demand. In the oil market, where there has been similar underinvestment, OPEC+ producers have limited or no spare capacity.”
UBS also sees supply dislocations in agricultural commodities spilling over into next year due to the continuation of the war in Ukraine, high energy prices, labor shortages and persistent climate-related issues.
Haefele contended that overall, commodities are “oversold,” and that investors will begin to be less concerned about short-term growth and more concerned about supply-side pressures from climate change, geopolitics and decarbonization efforts.
UBS maintains expectations for 15-20% returns across commodities over the next six to 12 months.
‘Irrational expectations’
The UBS view mirrored that of Wall Street giant Goldman Sachs, which highlighted in a research note Thursday that “irrational expectations make for unsustainable prices,” arguing that the model for commodity pricing is broken at present.
“Today, commodity markets appear to hold irrational expectations, as prices and inventories fall together, demand beats expectations and supply disappoints,” said Goldman’s Global Head of Commodities Research Jeff Currie.
“The only rational explanation in our view is destocking as commodity consumers deplete inventories at higher prices, believing they can restock once a broad softening creates excess supply,” Currie added.
Should this prove incorrect and this excess supply fail to materialize, however, he suggested that the restocking scramble would drive scarcity and push up prices substantially in the fall. This may force central banks to tighten monetary policy more aggressively and inflict a more prolonged economic contraction.
“Instead, markets appear to be pricing a soft landing outcome; minimal further increases in interest rates, dissipating inflation and sufficient economic growth to keep earnings well-supported into 2023,” Currie said.
“In our view, macro markets are pricing an unsustainable contradiction — it is difficult to square a softening FCI [Financial Conditions Index], a more accommodative Fed pivot, falling inflation expectations and drawing commodity inventories.”
Finally, cross-market curve shapes are flashing a warning signal to investors, Currie highlighted.
With the 2-year/10-year U.S. Treasury yield curve having flattened and now inverted – an event markets perceive as a reliable indicator of impending recession – commodity markets should have been heading into “contango,” Currie said, a situation in which the futures price exceeds the current price.
Commodity markets also tend to tighten most during the expansion phase of the business cycle, reversing course when rate expectations rise and the yield curve steepens into contango. When the yield curve flattens and a recession does not materialize, such as in 1995 and 2007, Currie noted that oil markets can “surge into further backwardation and yield curves steepen,” as the market reprices further tightening on the horizon.
Conversely, when a fundamental slowdown is underway, commodity markets are “generally in contango and physical supply chains are debottlenecking,” Currie explained.
“Today, equity and commodity markets are signaling to investors more persistent demand and higher commodity inflation, while rates and inflation curves are signaling an impending slowdown and softening of the economy,” he said.
“Until we see real commodity fundamentals soften, we remain convicted of the former, not the latter.”
Goldman therefore forecasts the S&P GSCI commodity index rallying 23.4% by the end of the year.
