While equities and bonds suffered major sell-offs in the first half of 2022, global commodities rallied fiercely. The Bloomberg Commodity Index shot up 30% by the end of June and the price of many raw materials surged to record highs, says Hakan Kaya, senior portfolio manager, Neuberger Berman.
Although prices have fallen somewhat in recent weeks, we believe a structural undersupply and overdemand imbalance still exists across many commodities. This indicates we may still be in the early stages of the cycle, and the asset class could see considerable upside over the long term.
Capex required
While many of the supply side challenges facing raw materials markets - including geopolitical and pandemic-induced logistical blockages - could conceivably be resolved in the near to medium term, of deeper importance is the persistent regime of underinvestment in commodities.
Returns have been poor over the last decade, so many investors are naturally hesitant when it comes to commodities. Additionally, increasing uncertainty around environmental regulation - such as cap-and-trade systems - makes it difficult to devise a valid discount rate for valuations in the sector.
The increased weight now given to environmental and social risks in sector analysis has raised a tall hurdle against investing in raw materials production. Moreover, those investors that are invested now tend to prioritise cash flow and dividend safety over growth-oriented capital expenditure. As such, there appears little prospect of meaningful additional supply, as neither investors nor governments are incentivised to fund it.
Enduring demand
Meanwhile, powerful structural drivers on the demand side are unlikely to abate. While Covid-19 relief measures are over, a broader set of policies aimed at redistributing wealth and reducing inequality - such as gasoline tax subsidies and caps on energy bills - will continue to stimulate demand for commodities from those on lower incomes. Higher wages and redistributive fiscal policies put more money into the pockets of a large demographic that typically spends a greater share of their income on food, energy and other raw materials.
Decarbonisation is also a redistributive policy, insofar as it stimulates the creation of new ‘green' industries and jobs, including heavy industrial jobs in manufacturing and infrastructure that are not easily offshored.
Moreover, while decarbonisation implies less demand for fossil-fuel commodities, the resulting electrification of the global economy will be highly metals-intensive. According to the International Copper Association, a typical internal combustion engine vehicle contains about 23kg of copper, whereas an electric car uses approximately 83kg - nearly four times as much.
Lastly, escalating geopolitical tensions and a greater understanding of the potential for global crises - such as pandemics - to threaten supply chains are increasingly fuelling protectionist measures, whereby policymakers focus on safeguarding key supplies such as food and energy. This increased trade fragmentation, or deglobalisation, is another reason many commodities will likely experience elevated prices over the long term.
Differentiated returns
Although price volatility in commodities markets will likely persist moving forward, this is common for many raw materials given the inelastic nature of their supply and demand. For those investors with the capacity to bear price fluctuations, commodities exposure can provide a number of key portfolio benefits amid the increasingly uncertain outlook for markets.
Aside from the likelihood for further price rises, commodities are experiencing higher yields as steep backwardation in futures markets continues to reflect supply scarcity and efforts to incentivise production.
A healthy allocation to commodities also provides diversification. Historically, commodities have proven to be negatively correlated with equities and bonds - a particularly attractive trait given the tight stock-bond correlation witnessed this year, in which both equities and bonds have fallen in tandem. With both bonds and stocks vulnerable to rising interest rates, this tight correlation could continue over the near to medium term.
In addition, commodities are historically positively correlated with inflation, acting as a reliable hedge against rising prices. They have tended to perform exceptionally well during ‘inflationary-bust' or stagflation scenarios, when economic growth has wavered - an increasingly probable reality over the coming months.
Allocate efficiently
In the short term, we expect energy commodities to generate the best returns for investors in a diversified commodities portfolio. Energy scarcity is increasing, as there is scant spare capacity in the OPEC+. Only the UAE or Saudi Arabia may be able to increase production, though not significantly, and Russian oil is sanctioned. Governments are subsidising demand via fuel subsidies, and we see demand increasing in mobility data amid the post-pandemic travel rebound.
We are also optimistic on industrial metals, given increased Chinese stimulus spending after the prolonged lockdowns across the region this year. Alongside industrial metals such as copper, we see increased demand for platinum and palladium - metals used for emissions-controlling catalytic converters - as automakers build up depleted inventories.
Longer term, we see increased metal demand from the metallisation of the energy space, with the transition to EVs well underway and many countries adopting greener, electric heating.
By Hakan Kaya, senior portfolio manager, Neuberger Berman.
