- Leaning Into Real Assets
- 2023-08-04 16:02
The U.S. economy is currently experiencing the best of both worlds—falling inflation and rising economic growth expectations. As a result, equity markets have seen a strong rally so far in 2023.
But commodities prices have not participated in the upswing. In fact, they have generally been moving in the opposite direction since November of last year—as indicated by the performance of the S&P GSCI Index, which was down by more than 14% over the past year as of July 24, 2023.
There are four primary reasons why commodity prices have weakened over the past year:
1) While the economic outlook has improved recently, recession risks remain elevated—particularly outside of the United States. Demand for commodities is highly sensitive to global economic growth, so this remains a damper on prices.
2) The Chinese property market, which is one of the largest drivers of commodities demand, has weakened considerably.
3) This past winter was surprisingly mild, especially in Europe, leading to very modest demand for energy commodities such as natural gas and oil.
4) The economic impact of Russia’s invasion of Ukraine has been more moderate than expected. Both Russia and Ukraine are large suppliers of both food and energy commodities, but thus far the supply disruption from the war has been less significant than expected.
As these concerns weigh on prices, commodity-related assets have become attractively valued. For instance, valuations for the S&P 500 energy sector currently fall in the 12th percentile of their 30-year history, while the broader index is in the 75th percentile, as of June 30, 2023.
There are, however, reasons to believe that this weakening trend in commodity prices could be in the process of reversing.
First, we are seeing some signs that the four headwinds driving the weakness are set to fade. Most notably, China has recently signaled its intention to provide more support to its property market, while Russia has recanted on a deal that allowed grain exports to move through the Black Sea.
We are also seeing signs that energy market supply levels may be peaking. For instance, one useful predictor of energy supply trends is the number of active oil and gas rigs in the U.S. Generally, when the number of active rigs begins to decrease, it is a sign that energy producers have recognized that the market has become oversupplied and are, therefore, making the necessary adjustments to put a floor on prices. In fact, rigs have been steadily decreasing throughout 2023 and doing so at an accelerated pace since February.
Given this backdrop of attractive valuations and improving fundamentals for commodity prices, now may prove to be a good time to increase allocations to commodity-related assets—especially when one considers the longer-term risks of a potential second wave of inflation.
While inflation appears to be on the path to moderation over the near term, there are reasons to be concerned that we could see a second wave in the coming years. As a result, our Asset Allocation Committee has recently increased its position in real assets, which includes a large allocation to commodity-related equities.
- Key Insights
- Although equities have rallied so far in 2023—supported by falling inflation and improving economic growth expectations in the U.S.—commodity prices have lagged.
- Our Asset Allocation Committee recently added to real assets equities, given attractive valuations for commodity-related assets and improving fundamentals.
Since the beginning of this year, equity markets have advanced as inflation and economic growth expectations improved in the U.S. However, despite this uptick, commodity prices have been moving in the opposite direction (Figure 1).
Commodities, which are highly sensitive to global economic growth, have been weighed down by elevated recession risks, especially outside the U.S. Demand has also been muted due to considerable weakness in the Chinese property market and a surprisingly mild winter, particularly in Europe, which reduced the need for natural gas and oil. Meanwhile, the supply impact of Russia’s invasion of Ukraine has been more moderate than expected.
Commodities Left Behind
(Fig. 1) Stocks versus commodities.
July 25, 2022, through July 24, 2023.
Past performance is not a reliable indicator of future performance.
Sources: Bloomberg Finance L.P., S&P, and MSCI. See Additional Disclosures.
Energy Stock Valuations Are Attractive
(Fig. 2) Monthly valuation percentiles over the past 30 years.
July 30, 1993, through June 30, 2023.
Actual outcomes may differ materially from estimates. Valuation is calculated as next 12 months price-to-earnings (P/E) ratios.
Sources: Bloomberg Finance L.P. and S&P. See Additional Disclosures.
But these headwinds may be fading as energy sector fundamentals improve. China has recently signaled its intention to provide more support to its property market, and Russia’s decision to prevent grain exports through the Black Sea could be disruptive to some global economies. Valuations for commodity‑related equities have therefore become attractive (Figure 2).
Further, the number of active oil and gas rigs—a useful predictor of energy supply trends—has been decreasing at an accelerated pace since February, an indication that energy supply levels may be peaking. With this backdrop, the commodities sector is likely to benefit amid strong demand and limited supply.
Inflation could also boost commodity‑related equities. Although inflation seems to be moderating in the near term, there are concerns that prices could rebound and surge higher, as they did during the early 1980s when the Federal Reserve eased restrictive monetary policy prematurely. As a result, our Asset Allocation Committee recently increased its allocation to real assets, which include a large allocation to commodity‑related equities.
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