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The increasing talks about a looming recession have dampened the near-term outlook for the commodities sector. Nevertheless, the case for commodities remains as the macro environment is still dominated by record inflation and supply tightness.
The fundamental outlook for the commodities sector is strong, and the recent price pullback could serve as longer-term buying opportunities, as we think that demand weakness is likely to be offset by the tightening supply.
In a high inflationary environment that we are currently in, commodities serve as a useful inflation hedge as their returns have historically been positively correlated with inflation levels.
China’s potential recovery would be a positive catalyst to the commodities sector, given that it is one of the largest commodity importers. President Xi Jinping has called for an “all out” effort to increase infrastructure spending this year in the hope of fuelling economic growth.
With diversified exposure to the energy, mining, and agriculture sectors, investors can consider the Blackrock Natural Resources Growth & Income Fund to get exposure to the commodities sector.
The commodities sector has rallied this year, outperforming other sectors of the market. For instance, within the S&P 500 sectors, the energy sector delivered the highest positive returns of 38.6% year-to-date to investors. But despite being one of the big winners so far in 2022, of late, there has been fears of a global recession which have raised caution within the commodities sector.
Figure 1: Energy sector has outperformed other sectors
Demand concerns are increasing as fears of a global recession heightens
In view of the high inflationary environment in which we are currently in, central banks around the world have embarked on an aggressive rate hike cycle. The Federal Reserve for instance, has hiked interest rates by 75 basis points for the second straight month in July in an effort to bring rampant inflation back under control. But with aggressive rate hikes underway, the economy becomes increasingly at risk of a recession.
The talks about a looming recession have dampened the near-term outlook for commodities. Given that the commodities sector is cyclical in nature, the prices of the underlying commodities have fallen amidst growing fears of slowing growth.
The International Energy Agency trimmed forecasts for oil consumption in view of the growing fears of a recession. Global oil demand growth has been marginally reduced to 1.7 million barrels per day (down slightly from the forecast of 1.8 million barrels per day in June) in 2022, to reach 99.2 million barrels per day.
Looking at base metals, a bleak demand outlook caused by recessionary fears was a contributor to the sell-off (Figure 2). The demand for metals was particularly impacted by a slowdown in economic activity in China as lockdowns in major cities. For instance, copper prices retraced in May after reaching an all-time high of USD 10,845/metric ton in early March, given that China is the largest consumer of this commodity (52% of the total global copper consumption volume).
Figure 2: Base Metals Price Index
Case for commodities
While we witness some demand concerns, we still cannot ignore that supply tightness persists when looking at the major categories of commodities — energy, metals and agriculture, given the following reasons:
Structural under-investment in the oil and gas sector
Unlike the 1970s and 2000s when capital expenditure (capex) grew alongside rising oil and gas prices, we are currently experiencing a contraction in capex even as we see a rise in price.
Structurally, the oil and gas sector is a market that is defined by underinvestment, and this is a persistent problem that is difficult to change. In fact, investment has been on a downward trend since 2014 (Figure 3).
Figure 3: Underinvestment in the energy sector
Many major markets have also found themselves short of refining capacity due to a combination of shutdowns, investments that were stalled by the pandemic, sanctions on Russia and a decision by China to limit petroleum exports. The result is that oil refiners are now enjoying some of their best ever processing margins in over a decade (Figure 4).
Figure 4: Oil refiners are enjoying some of their best ever processing margins
Inventories of metals are reaching lows
The metals markets is still facing some of the tightest supply conditions ever, with inventories dwindling globally and little sign of significant new supply (Figure 5). For instance, aluminium and nickel stocks have fallen the most this year as they are among the most exposed metals to disruptions in Russian supply.
Figure
5: Inventories of many base metals are at low levels
Beyond
this, longer-term structural trends provide the segment with multiple
tailwinds. Renewable energy technologies rely heavily on a number of key metals
and minerals, including copper, aluminium, zinc, cobalt, nickel and lithium. In
the longer term, the energy transition brings with it a strong demand for such
metals, and coupled with the lack of supply (Figure 6), would lift the prices
of these metals higher.
Figure 6: Metals needed for renewable energy technologies are in short supply
Food security concerns remain pertinent
Concerns about food security amidst Russia’s invasion of Ukraine, one of the world’s biggest grain and vegetable oil exporters remain. Russia had bombed the Black Sea port of Odessa on 23 July 2022, less than 24 hours after signing an agreement to guarantee the safe transit of Ukrainian grain exports.
This landmark agreement after months of negotiation was meant to be hailed as a vital step toward alleviating a global food crisis. While the first ship to carry Ukrainian grain has left the port of Odessa, Russia’s actions has nevertheless highlighted that large amounts of uncertainty surrounding this deal remains.
Not to mention, across the globe, food protectionism is on the rise as governments try to safeguard local supplies. Around 30 countries have taken steps to restrict food exports since the start of the war in Ukraine, with agricultural protectionism at the highest level since the food price crisis in 2007 and 2008.
Countries are restricting exports to cope with high prices that have been exacerbated by the war in Ukraine. For instance, Malaysia announced a ban on chicken exports earlier in June, while India has moved to curb wheat and sugar shipments, Indonesia has limited palm oil sales, and some other nations have issued grain quotas. Protectionism will likely continue in 2022, and there will be little relief from food inflation and high prices for consumers.
Figure 7: Food prices remain at elevated levels
Above all, extreme weather conditions are becoming more commonplace due to the effects of climate change. Agricultural supply is highly weather dependent and thus especially vulnerable. The recent heat waves in Europe, where temperatures soared above 40 degrees Celsius in France, Greece, Spain, and Portugal have threatened the seasonal harvest. While India, which accounts for 40% of global rice exports has been faced with a lack of rainfall in West Bengal and Uttar Pradesh. The country’s total rice planted area has shrunk by 13% due to lack of rainfall, taking a toll on the global agricultural supply.
Seeing the big picture
We are in unprecedented times with respect to the commodities sector. The convergence of multiple factors – including war, underinvestment in supply, record inflation and energy transition has created many opportunities within this space.
Moreover, the commodities sector has historically been positively correlated with high inflation (Figure 8). For instance, the S&P Global Natural Resources Index has a 10 year correlation of 0.6 with the US CPI Index, much higher as compared to the S&P 500 Index, with a correlation of 0.2.
Figure 8: Commodities sector has historically been an inflation hedge
High inflation continues to remunerate throughout the global economy. Despite the US CPI year-over-year rate dropping from 8.5% in July from 9.1% in the previous month, inflation still remains at elevated levels (Figure 9), and the high inflationary environment which we are currently in, benefits the commodities sector.
Figure 9: US consumer prices rose by 8.5% on a year-over-year basis in July 2022
While the Fed has responded to the high inflation data seen this year by hiking interest rates, it is important to note that the Fed has little influence over the supply-side drivers that have underpinned the surge in commodities like crude oil, agriculture products.
Not to mention, China’s recovery would be a positive catalyst to the commodities sector, given that it is one of the largest commodity importers. President Xi Jinping has called for an “all out” effort to increase infrastructure spending (Table 2) this year in the hope of fuelling economic growth. These infrastructure projects are generally metal intensive, and local governments have been issuing bonds at a record pace to fund industrial parks, transportation networks, water projects, mobile networks and data centres.
Table 2: Infrastructure projects to stimulate China’s GDP growth
|
Funding source |
Value (Trillion Yuan) |
Ratio used for infrastructure (%) |
Infrastructure Spending (Trillion Yuan) |
|
General public budget spending |
26.7 |
8.7 |
2.3 |
|
Special local government bonds |
5.2 |
60.0 |
3.1 |
|
Spending related to land sales |
7.4 |
10.0 |
0.7 |
|
Policy bank funding |
1.1 |
100.0 |
1.1 |
|
Total |
7.2 |
||
|
Source: Bloomberg calculations based on official statement and reporting |
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As such, the macroeconomic landscape coupled with the confluence of factors mentioned above, makes an investment case for this asset class, and thus investors may complement their core portfolio with an exposure to commodities for diversification purposes.
Consider the Blackrock Natural Resources Growth & Income Fund
One way which investors can gain exposure to the broader commodities sector is via the Blackrock Natural Resources Growth & Income A2 USD Fund. This fund aims to achieve capital growth and an above average income through investing in equities (minimum 70% of NAV) whose predominant economic activity is in natural resources.
We believe that this fund is representative of the commodities sector, with an allocation to energy, mining and agriculture sectors (Figure 10). Its benchmark is the S&P Global Natural Resources USD Index which is one-third energy, one-third mining and one-third agriculture.
Figure 10: Sector allocation of the Blackrock Natural Resources Growth & Income Fund
The inclusion of agriculture-related companies like fertiliser producers (e.g.Nutrien, CF Industries) and food companies (e.g. Bunge), differentiates it from some of its natural resources peers such as the JP Morgan Global Natural Resources A (acc) USD Fund, which instead focuses only on energy and mining. Not to mention, the Blackrock Natural Resources Growth and Income Fund has also outperformed its peers over the longer-term (Figure 11).
Figure 11: Blackrock Natural Resources Growth & Income Fund has outperformed its fellow peers
Table 3: Top ten holdings of the Blackrock Natural Resources Growth & Income Fund
|
Rank |
Holding Name |
Weight (%) |
|
1 |
Glencore PLC |
7.48 |
|
2 |
Shell PLC |
7.47 |
|
3 |
Exxon Mobil Corp |
6.33 |
|
4 |
Nutrien Ltd |
5.08 |
|
5 |
Total Energies SE |
4.95 |
|
6 |
CF Industries Holdings Inc |
4.12 |
|
7 |
ConocoPhillips |
3.60 |
|
8 |
Freeport-McMoRan Inc |
3.42 |
|
9 |
Chevron Corp |
2.77 |
|
10 |
Deere & Co |
2.75 |
|
Source: Blackrock, iFAST Compilations Data as of 29 July 2022 |
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All in all, the commodities sector has rallied this year underscoring their credentials as a hedge against rising inflation. More importantly, beyond the immediate ebb and flow of commodity prices, enduring trends underpin this particular asset class, making this sector one to consider.
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