The outlook for commodity markets may be brighter than many investors appreciate, given recent price action and the current state of the global economy. Recession risk is on the rise, to be sure, but for those with longer-term horizons who can look through near-term volatility, our models at Rosenberg Research are saying that now is a good time to add exposure.

From cyclical tailwinds such as a weaker U.S. dollar to depressed investor sentiment and positioning (which are contrarian positives) and structural demand-supply imbalances, there are good conditions for commodities over the medium term. The fact that prices are close to cycle lows (the Bloomberg Commodities Spot Price Index is down 29 per cent from its peak in mid-2022, bringing valuations to near rock-bottom levels) is a clear sign that there is excessive pessimism “in the price.”

Additionally, commodities are a great diversifier, and that just adds to our conviction.

We do acknowledge that global recession risk is elevated, especially as manufacturing activity remains depressed and China is facing a wave of excess capacity. However, the weak price performance of commodities overall implies that recession risk is priced in already. Additionally, we see new demand counterbalancing the demand destruction from China over the medium term as other emerging countries in Asia (for example, India and Vietnam) expand their manufacturing capabilities to capture market share vacated by China.

With inflation inching back to target and a loosening of labour market conditions, the U.S. Federal Reserve is set to unwind the sharpest tightening cycle in four decades. This invariably translates into a weaker U.S. dollar, with a similar unwind seen in the early 2000s and in the wake of the global financial crisis, when we saw the dollar index weaken by 33 per cent and 23 per cent, respectively. Though the DXY dollar index is already down 11 per cent from its late 2022 peak, our “fair value” models indicate further downside ahead, with the index remaining the most overvalued of the currencies we track (down roughly another 10 per cent on this basis).

Commodities have a negative correlation to the direction of the greenback, given that they are priced in dollars. For example, through the bear market in the U.S. dollar from 2002 to 2007, the Bloomberg Commodities Spot Price Index was up a whopping 353 per cent. Overall, the correlation of 12-month rolling returns of all commodities against the DXY dollar index is down 42 per cent, albeit by varying degrees. Natural gas (down 3 per cent) and cattle (down 8 per cent) have the smallest negative correlation to the U.S. dollar, while copper (down 46 per cent), gold (down 44 per cent) and platinum (down 43 per cent) have the largest, implying that metals will likely be the biggest beneficiaries as the U.S. dollar continues its journey downward.

Investors have abandoned commodity exposure, and the asset class is completely unloved. Overall sentiment and positioning in the space are negative, increasing the odds of a surprise to the upside on any positive news. In terms of positioning, average CFTC net positioning across commodities is at a lowly 20th percentile reading, while 12-month rolling net flows into natural resources ETFs as a percentage of total ETF flows are at a 17th percentile reading. What’s more, Consensus Inc.’s Bullish Sentiment Index for all commodities averages at a reading of 42, which sits at a 21st percentile, too, implying an overall bearish sentiment among market participants. These are contrarian signs. As everyone piles on the “short” side of the trade, taking the other side offers a chance to benefit when the herd reverses course as they begin to sniff the inevitable recovery.

It’s not just cyclical factors and investor sentiment; the structural supply/demand backdrop across commodities is positive for prices, too.

Here are the key demand drivers:

• Energy commodities: Goldman expects demand to peak out in 2035 at 110 million barrels a day (b/d), and OPEC+ expects demand at 106 million b/d in 2045 – a steady increase from 100 million b/d in 2023. Oil and natural gas are expected to broadly retain their joint share of total energy demand per OPEC+. While details of demand from different forecasters vary, it is becoming clear that overall demand for oil is expected to stay strong as the transition to greener sources of energy lags and the world’s energy needs increase at a steady pace, the result of a changing climate (the need for more air conditioning), a growing number of generative AI data centres and increased industrialization in the developing world.

• Industrial metals and minerals: Copper (wiring needs, industrial machinery, construction) and aluminum (long-distance wires – for its high-tensile strength – car manufacturing and other industrial uses) are seeing increased demand as the world beyond China focuses on manufacturing, creating more demand while the supply side has yet to catch up. The transition to cleaner sources of energy is adding to uranium (low-emission nuclear energy is making a comeback) and lithium (used in EV batteries) demand, while securing their supply remains relatively challenging.

• Precious metals: As geopolitical uncertainty remains elevated, precious metals such as gold (up 29 per cent over the past year) and silver (up 18 per cent) continue to shine. Jewellery demand from India is also up (with about 10 million weddings annually, wedding jewellery accounts for 55 per cent of gold demand in India, and this market is expected to see 21-per-cent annualized growth over the next three years), as is demand from central banks (19-per-cent annualized growth over the past 13 years), while supply is finite, particularly at cheap levels. As the marginal costs of production go up, so will gold prices. In fact, our target of gold at US$3,000 an ounce is now within striking distance.

All in, while there are recession risks on the horizon, there are multiple cyclical and structural tailwinds lining up behind all subgroups of commodities. With overall weakness in prices, commodities are unloved and under-owned, making this current downturn a great opportunity to increase portfolio allocation from a medium- to long-term perspective.

Source: The Globel and Mail