Asset Allocation

Leaning Into Real Assets
Tim Murray, CFA, Capital Markets Strategist Multi‑Asset Division

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.

And finally,

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.

Line charts showing that the MSCI All Country World Index and the S&P 500 Index have rallied and trended upward since November 2022, but performance for the S&P GSCI Index has been negative.

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.

Line charts comparing the overall valuations of stocks in the S&P 500 Index with the valuations of stocks within the energy sector of the S&P 500 Index over the past 30 years. Valuations for the energy sector are in the 12th percentile of their 30-year history, while valuations for other stocks in the index are in the 75th percentile.

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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Additional Disclosures

MSCI and its affiliates and third party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such

The S&P Indices are products of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”) and has been licensed for use by T. Rowe Price. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); T. Rowe Price’s Products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P Indices.

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Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of August 2023 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Actual outcomes may differ materially from any estimates or forward-looking statements made.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Commodities are subject to increased risks such as higher price volatility, geopolitical and other risks. Investments in certain industries that involve activities related to real assets may be more susceptible to adverse developments affecting those industries and may perform poorly during a downturn in any of those industries. All charts and tables are shown for illustrative purposes only.

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