Leaning Into Real Assets

Video Transcript

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 commodity 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.