After a decade-long bear market, commodities are showing signs of life. We see further upside potential despite significant repricing from pandemic lows, driven by a supportive macro backdrop, attractive fundamentals and growing investor demand for inflation-sensitive assets.
- Global GDP growth in 2021 is expected to be the highest in decades as the pandemic downscales and economies reopen, boosting demand for raw commodities.
- Supply/demand fundamentals for many commodities appear the most attractive in almost a decade according to our analysis, which we believe are likely to persist.
- Commodities have historically been one of the best ways to hedge against unexpected inflation, typically experiencing significant outperformance when inflation surprises on the upside.
Commodity prices continue to set records across a wide swath of sectors
The Bloomberg Commodity Spot Index climbed to a 10-year high in May following broad-based participation in the rally. Surging industrial usage, increasingly from green technologies, drove copper to an all-time high. Palladium began the month at a record high above $3,000 per ounce before consolidating a portion of its earlier gains. Grains touched their highest levels in more than eight years. Lean hog prices have nearly doubled this year and stand at their highest level since 2014 as a second wave of African swine fever in China has resulted in a decline in the herd population. While still far from its record, West Texas Intermediate crude oil has returned to 2018 price levels as producers have maintained supply discipline in the face of rising energy consumption.
Macroeconomic conditions remain highly constructive for commodities
The synchronized global recovery behind the demand push is being aided by $25 trillion in planned fiscal and monetary stimulus globally. In particular, China (a major consumer of commodities) is expected to grow close to 8.5% in 2021 despite recent policy normalization, further bolstering the synchronized global recovery. We believe the potential for a lasting economic recovery and above-trend global growth bodes well for an extended period of strong commodity consumption.
Supply/demand imbalances likely to persist
Our analysis suggests that fundamentals for many commodities are the most attractive in almost a decade. Inventories for most commodities were at multi-year lows before the pandemic hit, leaving producers scrambling to meet the now surging demand as economies reopen. A lack of investment in supply in recent years means ramping up output will take time. Also, COVID-related production issues and supply chain constraints that plagued many sectors during the pandemic, (particularly metals), are still lingering. For grains and softs, the weather has also played a major part in the price moves this year, with La Niña–induced droughts in Argentina, Brazil and the United States severely impacting production.
2021 inventory estimates are below their respective 10-year peaks and averages for most commodities.
Supply shortage
Estimated inventory
At May 31, 2021. Source: BMO, USDA, IEA, World Gold Council, S&P Global Platts, GFMS, Bank of America, UBS, Macquarie, Wilton Agriculture Strategies, Cohen & Steers proprietary analysis.
Data quoted represents past performance, which is no guarantee of future results. This chart is for illustrative purposes only and does not reflect information about any fund or other account managed or serviced by Cohen & Steers. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. The mention of specific sectors is not a recommendation or solicitation to buy, sell or hold a particular security and should not be relied upon as investment advice. See below for index definitions and additional disclosures.
Sector views
Energy: Rebalancing likely to keep upward pressure on petroleum prices. Inventories within the 38-country Organization for Economic Cooperation and Development are now below their five-year average, and a significant deficit is forecasted for the second half of 2021, driven by strong global demand growth and expectations of OPEC+ output growing only modestly. This may keep Brent crude above $70 per barrel over the next 12 months. We are now slightly underweight natural gas, with the recent price move likely fully discounting current shoulder month fundamentals, in our opinion. However, our longer-term view remains constructive, driven by stabilizing U.S. production, strong liquid natural gas exports and growing power generation demand.
Industrial metals: Cautious, with prices well above pre-COVID levels. There are indications that high prices have started to reduce purchasing by key Chinese metal consumers, and the government has implemented measures to curb speculation on their exchanges. In addition, the second half of the year should see increased nickel and zinc supplies, which may coincide with a demand slowdown. We prefer copper for its relatively tighter forward balances and its demand linkage to the green energy revolution.
Softs: Mixed outlook, with a favorable view of coffee. We believe the market has not yet fully discounted the magnitude of the upcoming Brazilian coffee crop disappointment. Additionally, coffee producers may need to buy back previous hedges in the face of soaring prices and lower-than-expected production, putting further upward pressure on prices. We are bullish on cotton’s prospects and continue to forecast that U.S. acreage will ultimately fall below current market expectations due to rising prices for competing crops, such as corn and soybeans. We remain bearish on sugar, as favorable production economics will likely keep the 2021/2022 Brazilian crushing season tilted toward sugar yet again.
Grains: Declining inventories expected in corn, soybeans and wheat. We favor corn and soybeans on a medium-term basis, as U.S. stocks-to-use are on pace to hit their lowest level in nearly a decade at the end of the 2020/21 marketing year (and will likely stay there in the 2021/22 marketing year given strong export and biofuel demand). Prices will need to rise further to defer demand until after the 2021 U.S. harvest and to incentivize southern hemisphere farmers to expand their plantings in the second half of 2021. However, the near term is fraught with risks, ranging from favorable early-season crop condition ratings to potential stocks and acreage surprises in the USDA’s Grain Stocks and Acreage reports (which are due out at the end of the month). We continue to favor soybean oil over soybean meal, as the demand outlook for renewable diesel and biodiesel remains rosier than that for U.S. and global protein feed demand.
Precious metals: Tempering our outlook given potential upward pressure on real yields. We believe the reopening U.S. economy and the improving labor market will translate into upward pressure on inflation-adjusted yields, which suggests a limited upside for gold. This same dynamic applies to silver, albeit to a lesser extent given its industrial demand and leverage to green energy spending.
Livestock: Elevated supplies of cattle-on-feed likely to keep pressure on prices in the near term. Large placements during the fall of 2020, combined with drought-induced placements this spring, may keep the market well supplied in the near term. Longer term, a smaller calf crop in 2020 (due to poor cow-calf producer economics) may result in lower slaughter and beef production into 2022; a contraction in the cattle herd has historically been supportive for cattle prices. For hogs, we believe the market has overestimated the U.S. herd size and the backlog of animals resulting from meatpacking plant closures in 2020. However, while we think fundamentals for the U.S. hog market are on a solid footing, valuations appear to be extremely stretched and herd-building in China poses a potential risk.
Attractive portfolio benefits driving investor interest
- Inflation hedging: Commodities’ historical sensitivity to unexpected inflation demonstrates their potential to serve as an effective inflation hedge. An inflation beta of 9.2 for commodities since 1991 (see below) is the highest among listed real assets, indicating that commodities typically outperformed their long-run average by 9.2% for every 1% that realized inflation exceeded the prior-year estimate.
- Diversification potential: Commodities historically have had a low beta to global stocks (0.43 over the post-1991 period represented in the exhibit below), adding to potential diversification benefits beyond inflation sensitivity.
- Relative value: Commodity valuations relative to both stocks and bonds are at their lowest points in at least 30 years at a time when many financial assets are richly priced.
Commodities have historically been one of the best hedges against unexpected inflation.
Inflation defense
Beta to inflation surprise (y/y realized vs. expected), 5/1991–3/2021
At March 31, 2021. Source: Bloomberg, Thomson Reuters Datastream, Cohen & Steers proprietary analysis.
Data quoted represents past performance, which is no guarantee of future results. The chart above is for illustrative purposes only and does not reflect the performance of any fund or account managed or serviced by Cohen & Steers. There is no guarantee that investors will experience the type of performance reflected above. An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment. Inflation beta calculates the linear regression beta of 1-year real returns to the difference between the year-over-year realized inflation rate and lagged 1-year ahead expected inflation, including the level of the lagged expected inflation rate. Expected inflation as measured reflects median inflation expectation from University of Michigan Survey of 1-Year Ahead Inflation Expectations. Realized Inflation is measured by the Consumer Price Index for all Urban Consumers, published by the U.S. Bureau of Labor Statistics. Linear regression is a statistical method that models the relationship between a dependent variable and one or more explanatory variables. See below for index associations, definitions and additional disclosures.
Closing thoughts
After a challenging decade for commodities, we see potential for a sustained, multi-year, broad-based rally, driven by three key factors:
- A highly supportive macroeconomic backdrop
- The strongest supply/demand fundamentals in a decade
- Attractive portfolio benefits—including inflation sensitivity—driving speculative inflows
For more information about the role commodities can play in a diversified real assets portfolio, please contact your Cohen & Steers representative or read our latest insight on building inflation-resilient portfolios.
ABOUT THE AUTHORS
Ben Ross, Senior Vice President, is Head of Commodities and a portfolio manager for Cohen & Steers’ commodities strategy.
Nick Koutsoftas, Senior Vice President, is a portfolio manager for Cohen & Steers’ commodities strategy.
FURTHER READING
Secular drivers of inflation
Recent data indicates a slowing inflation trend, yet risks persist. Secular forces suggest that a prolonged elevated inflation period is underway with the potential for periodic price spikes. Factors driving long-term inflation include commodity underinvestment, tight labor markets, geopolitics, deglobalization and fiscal uncertainty. We see parallels to past inflationary eras, which highlight the difficulty of controlling inflation. While not predicting a return to 9%, the expectation is for a decade of higher-than-accustomed inflation, underscoring the importance of having a real assets allocation.
Commodities’ redemption
Commodities have delivered historically strong performance, providing inflation hedging, diversification and compelling returns, with the potential to contribute meaningfully to a real assets allocation.
Overall commodity market performance quotes represent total return based on Bloomberg Commodity Index Total Return; sector returns represent market price performance based on the Bloomberg Commodity Index; in U.S. dollars as of 3/31/2021. An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment.
Data quoted represents past performance, which is no guarantee of future results. Diversification does not ensure a profit or protect against loss. The views and opinions are subject to change without notice and represents an assessment of the market environment at a specific point in time, should not be relied upon as legal, investment or tax advice and is not intended to predict or depict performance of any investment. We consider the information to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of appropriateness for investment. Investors should consult their own investment professional with respect to their individual circumstances. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin. There is no guarantee that a market forecast made in this commentary will be realized. The mention of specific securities or sectors is not a recommendation or solicitation for any person to buy, sell or hold any particular security and should not be relied upon as investment advice.
Risks of investing in commodities
An investment in commodity-linked derivative instruments may be subject to greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. The use of derivatives presents risks different from, and possibly greater than, the risks associated with investing directly in traditional securities. Among the risks presented are market risk, credit risk, counterparty risk, leverage risk and liquidity risk. The use of derivatives can lead to losses because of adverse movements in the price or value of the underlying asset, index or rate, which may be magnified by certain features of the derivatives. No representation or warranty is made as to the efficacy of any particular strategy or fund or the actual returns that may be achieved.
Futures trading is volatile, highly leveraged and may be illiquid. Investments in commodity futures contracts and options on commodity futures contracts have a high degree of price variability and are subject to rapid and substantial price changes. Such investments could incur significant losses. There can be no assurance that the options strategy will be successful. The use of options on commodity futures contracts is to enhance risk-adjusted total returns. The use of options, however, may not provide any, or only partial, protection for market declines. The return performance of the commodity futures contracts may not parallel the performance of the commodities or indexes that serve as the basis for the options it buys or sells; this basis risk may reduce overall returns.
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