China, costs, contango, and currency still key drivers…
Commodities as an asset class have underperformed equities and fixed income in recent
years. Yet commodities have behaved as advertised, delivering negative returns on
flagging global growth and inflation. After all, world nominal GDP in USD has struggled
to expand in recent years, posting an annualized increase of 0.8% in the 2011-15 period.
That compares to a staggering 8.2% in the previous 10 years. So is this the time to add
to commodity positions? Not yet. In our view, a cocktail of “4Cs”—currency headwinds,
China headwinds, contango headwinds, and cost deflation headwinds—that has driven
commodity investor returns into negative territory is not about to change.
…suggesting it is still early to overweight commodities
A simple risk parity portfolio of equities, bonds, and commodities would point to keeping
commodity exposure well below historical averages at the moment. High volatility mixed
with negative returns has made commodities less attractive than equities or bonds.
Moreover, the fundamental outlook still remains blurred by the “4Cs”. Surely, higher US
interest rates could push curves into backwardation at some point next year, reducing
the negative carry on commodity investments. One may even argue that the massive
commodity cost deflation of recent years could ease. But our economics team believes
that the strong USD trend, coupled with a slowing Chinese economy, is here to stay.
Structural CNY/China weakness remains a major issue…
Recent EM FX weakness should give pause for thought. In particular, our analysis shows
the disproportionate impact of China FX on all commodities, with even nat gas, sugar, or
wheat tending to respond strongly to movements in the CNY. Other EM FX elasticities
are large too, but generally more muted with the exception of pairs such as copper and
Chile. This evidence is concerning. After all, China’s GDP in USD expanded by 25% in
2007 on strong GDP growth, high domestic inflation, and fast-paced CNY appreciation.
If CNY strength reverses, Chinese inflation eases, and GDP growth slows down further,
China’s nominal GDP in USD will likely stagnate. And so will global GDP in USD.
…but a strong G3 economy will ultimately benefit EMs
Surely there is no imminent catalyst to reignite EM FX strength and FX overshooting is a
risk given recent China capital outflows. Still, there is some light at the end of the
tunnel. Our economists point out that a strong economic backdrop for G3 economies
(US, Eurozone, Japan) historically benefitted EMs. Our team forecasts precisely a surge
in global GDP growth from 3.2% to 3.8% from this year to next, so investors may want
to consider “buying on dips”. Pronounced cyclical rallies, a key feature of the market in
the 1980s and 1990s, may happen at lower commodity price levels. As the drastic recent
moves in oil suggest, we think commodity investors will just have to turn much more
tactical. As such, we believe strategies like COT momentum should continue to perform
in this environment.