Returns in the commodities markets have improved over the past year amidstronger macroeconomic activity and supply-side tightening, and our outlookfor the next 12 months has brightened.
While considerable uncertainties remain for all commodity sectors, webelieve the worst market trends may be behind us. As we look ahead to thenext 12 months, commodities will likely reclaim a diversifying role inportfolios, given growing inflation risks and shrinking correlationsbetween commodities and other assets.
At this point in the business cycle, we think investors should considerpositioning commodities allocations to at least match benchmark targets, ifnot modestly exceed them.
Supply and demand trends both look more favorable
A quick look at recent history: The “commodity supercycle” of the late1990s through the 2008 financial crisis – a period when most commoditiesexperienced double-digit annual real price growth – came to an end asinvestment in supply, partly fueled by low interest rates over the priordecade, led to rapid inventory builds and a correction in prices. The lowerprices caused a sharp pullback in capital expenditures, which hastranslated into slower output growth for some commodities and outrightcontraction for others. With OPEC curtailing oil output and Chinarestricting capacity in metals, supply-side adjustments have acceleratedover the past 12 months. And while we expect capex to begin to grow again,we view this as necessary to meet future demand and not in itself a bearishindicator.
We see reason for optimism on the demand side of the equation as well.Demand growth has been strong for commodities over the past few yearsdespite rather tepid global economic expansion. With support from lowprices, oil demand has been materially above trend, and as of December 2016had witnessed the highest two-year growth period in a decade. And given PIMCO’s cyclical forecast of acceleration in both emerging market and developed market growth as thefocus on austerity recedes and infrastructure investment increases, webelieve demand will likely remain strong.
These trends provide a favorable backdrop to raw materials demand.Furthermore, commodity market returns tend to be highest during the latterhalf of the business cycle (where we likely are now), given that prices aredriven more by current economic conditions and the near-term supply/demandbalance. This is in contrast with equities, which represent a discountedstream of future cash flows and thus provide more of a forward-lookingbarometer. Continued economic growth, coupled with supply-sidenormalization and a maturing business cycle, should create room for acontinued price recovery.
At a high level, we’re broadly constructive on both petroleum and naturalgas due to strong demand and insufficient investment in supply, and we seescope for improvement in industrial metals prices due to accelerating GDPand infrastructure growth. We’re more cautious on agriculture given ongoinghigh inventories and still adequate supply growth, assuming normal weather.
The oil market outlook is always a bit complicated, in part due to theimpact OPEC can have on balances. For all the attention paid to changes inU.S. shale output, OPEC is capable of swinging oil balances more in asingle month than U.S. shale can in a year. As a result, any oil outlookmust make some material assumptions about OPEC’s intentions at the upcomingMay and November meetings.
Rewinding to 2016, the oil market hit an inflection point in the summer asdeclining non-OPEC output and strong demand signaled a nascent marketrebalancing. A fourth-quarter surge in OPEC output looked set to delayrebalancing by yet another year before last-minute negotiations betweenOPEC and key non-OPEC producers, mainly Russia, led to an agreement tocurtail output, accelerating the drawdown of surplus inventories during2017.
While this deal has reignited non-OPEC investment, we expect OPEC tomaintain discipline through year-end 2017, allowing inventories to continueto normalize. The main risk is that OPEC fails to renew the deal andincreases output just as the supplies resulting from short-cycle (primarilyshale) investment in the U.S. begin to accelerate. Our baseline view isthat OPEC will see an incomplete job when it meets in May and extend thedeal – and as a result, we expect Brent to average in the mid-$50s in 2017and 2018. We could revise our price view higher should production costsbegin to pick up at a faster rate than producers can improve efficiency.
We are constructive on natural gas, particularly relative to the forwardcurve. As Figure 1 shows, if not for yet another winter of near-recordwarmth, natural gas prices would likely be much higher: Comparing this pastwinter to the 2014–2015 winter (the last time weather was close to averageseasonal temperatures), declines in supply, expansion in exports andincreases in underlying demand are driving improved balances. Remarkably,these shifts were nearly enough to absorb the lack of typical winterweather-related demand.
Looking ahead, we see strong demand for U.S. exports, particularly giventhe ramp-up of five liquefied natural gas (LNG) export trains between 2016and 2017 and growing domestic demand, with several large-scalepetrochemical plants coming online. This would lead to a call on domesticsupply growth that producers will be unable to fulfill at current prices.Our top-down and bottom-up production forecasts show that output isunlikely to match pipeline capacity growth and that additional upstreaminvestment will be needed to satisfy growing demand.
Metals broadly are closely tied to the global growth cycle and specificallyto China’s economy. Although growth in GDP and industrial activity in Chinahave slowed from the heady pace of the previous decade, the economy is nowmuch larger, and aggregate demand growth remains supportive from a volumeperspective. In PIMCO’s view, China’s public sector credit “bubble” and itsprivate sector capital outflows will likely remain under control this year,and we expect growth to slow to a 6%–6.5% band as policymakers prioritizefinancial stability over economic stimulus ahead of the 19th National PartyCongress this fall. Any trade war with the U.S. will likely be engaged viawords (and tweets) rather than action, and we expect the yuan to depreciategradually against the dollar by some 4%–5%.
This backdrop is still conducive to continued demand growth. In addition,underinvestment globally and the rationing of surplus supply capacity –recent aluminum smelter closures being a prime example – have broadlysupported prices. With global PMIs (purchasing managers’ indices – keyindicators of economic activity) accelerating to the highest level in adecade and infrastructure spending likely to rise, the backdrop forindustrial metals has improved considerably.
We are reasonably cautious on precious metals. Given PIMCO’s baseline viewfor modest global GDP acceleration and U.S. Federal Reserve rate hikes, wesee scope for precious metals to trade lower this year. While gold doesbenefit from higher inflation given its exposure to the levels of realinterest rates, which are still low by historical standards, we prefer hardcommodities that have seen advancements in supply-side adjustment and standto benefit from improving economic activity for hedging inflation risk.
Among the commodities sectors, we are least optimistic about agriculture.Large crops in recent years have led to a substantial inventory overhang,and inventories will likely remain high given that total acres planted havebeen slow to drop. It’s worth noting, however, that while we believeagriculture commodities will remain depressed, farmers in North America arejust beginning to plant the new year’s crop, and its size and quality couldinfluence our outlook.
Agriculture has the shortest pricing and inventory cycles of thecommodities markets due to a supply cycle that resets every year. Thismeans that while supply can respond annually to higher prices, just one badcrop can wipe out even large inventory overhangs. Our outlook could changematerially as we enter the summer months – the key yield determinationperiod – if poor weather hurts yields. While the outlook for theagriculture sector is benign in aggregate assuming trend yields, we seeroom for portfolio optimization. For example, we view the shift in acresplanted toward soybeans and away from corn, given recent prices, willsupport corn going forward at the expense of the oilseed complex.
Investment and portfolio allocation outlook
We believe commodities allocations could play several key roles ininvestors’ portfolios over the coming year:
The correlation of commodities returns to other asset classes, such asequities and the U.S. dollar, as well as correlation within the commodityspace, has returned to the historical norms we saw before the commoditiessupercycle and global financial crisis (see Figures 2 and 3).
This is an important point to factor into portfolio construction. Duringthe financial crisis, the high correlation of commodities to equities andother asset classes was disappointing and frustrating to many investors.While commodities as a group will always retain a beta link to global GDP,the recent reductions in correlation and increasing dispersion within thecommodity space are evidence that the idiosyncrasies of each commodity willlikely differentiate its returns going forward. This shift points to therole commodities can play as a portfolio diversifier – and with centralbank liquidity receding, we expect such diversification to become even moreimportant.
As inflation concerns have mounted over the past few months, we have seen acorresponding rise in investor interest in commodities. Historically,commodities have demonstrated a positive beta to inflation and, moreimportantly from a portfolio construction standpoint, a positive beta toinflation surprises. With the focus on austerity diminishing, anincreased government desire to spend on infrastructure, and improving laborconditions, we see upside risks to inflation in much of the world. Thisbackdrop is favorable for commodities, particularly hard commodities suchas base metals and petroleum.
Potential for positive ‘roll yield’
Surplus markets have dominated commodities over most of the past 10 to 15years, resulting in low or negative roll yields on futures contracts that have hurt commodity index returns. While the rollyield implied by the 12-month forward curves in the Bloomberg CommodityIndex remains negative at roughly −2%, we note that this has improvedsignificantly from −6% a year ago. And should OPEC meet its stated goal ofreturning oil inventories to historical averages, it’s quite possible thatthe roll yield for the most impactful commodity in indices will turnpositive. We even can envisage natural gas backwardation (when active futures trade at higher prices than futures contracts for themonths ahead), as has occurred at times over the past year, if and when theweather supports increased demand.
In our view, active producer hedging in the longer-date futures for bothnatural gas and oil are depressing forward prices below the values we’dexpect. While this prevents higher prices today, it generally serves tosteepen the forward curve and improve roll yield. We note that what we’reanticipating is not anomalous, but rather a normalization of the commoditycurves to trade much like they did before the supercycle; shale primarilygives some certainty and definition to the long-dated supply and hence thelong-dated part of the forward curve. In this environment, much like theearly 2000s, commodities markets tend toward backwardation when demand isstrong or supplies shrink, and trade in contango (with futures prices exceeding the expected future spot price) when theopposite is true.
Discussions of roll yield often include statements to the effect thatcommodity equities are a superior way to get commodity-related exposure.However, our research shows that after accounting for the equity beta incommodity equities, they have not outperformed commodity futureshistorically. (To learn more, see “Commodity Investing: A New Take on Equities Versus Futures.”)
Policy risks complicate the commodity outlook
“Stable But Not Secure” has been a secular theme informing PIMCO’s investment process for nearlya year now, with a focus on uncertainties. Beyond the “normal” geopoliticalrisks typically present in these markets (and which tend to be supportivefor commodity prices), we see a few key policy-related risks today:
We view OPEC policy as the biggest area of risk to the oil markets. Wedon’t dispute that U.S. shale supply and shifts in shale inflation willhave a material impact on where the long-term futures curve is anchored,and on balances 12 to 24 months forward. However, OPEC production decisionscan rapidly swing balances in the short term. While debate swirls aroundwhether the U.S. will grow by 600,000 barrels per day (b/d) or 1 millionb/d in all of 2017 (and whether this is repeatable in 2018), OPEC couldmove output by 1 million b/d by June if it decided to do so.
U.S. tax policy
The potential imposition of a border adjustment tax (BAT) in the U.S. couldhave significant implications for commodities (although we assign a lowprobability to its passage given the lack of political support). The mostdirect impact on commodities of the BAT – which would tax imports and offertax credits for exports as part of an overall tax policy overhaul – wouldbe to increase the price of U.S. deliverable and traded commoditiescompared with the same commodities abroad by roughly the magnitude of themarginal tax rate (20%).
While this could benefit key components of the commodities indices, such asWTI crude, RBOB (gasoline), diesel fuel and Henry Hub natural gas, we thinkoverall it would lower the price of non-U.S.-based commodities, such asBrent crude, through a few primary mechanisms: 1) a stronger U.S. dollarthat will depress global production costs, 2) a test of OPEC’s ability andwillingness to coordinate production when its market share is being cededto U.S. producers, who see higher prices and improved return on investment,and 3) slower growth in emerging markets, which is particularly relevant tocommodities given their size and commodity-intensive growth.
While statements from the new U.S. administration have at times beencontradictory, policymakers have generally expressed a fairly negative viewtoward global trade. Changes to the latest G-20 communiqué highlight justhow far trade has moved up the agenda in Washington. Given the globalnature of tradable commodities and the importance of petroleum in globaltransport, growing trade frictions would be disruptive to both regionalmarkets and final product demand.
A hawkish mistake by central banks
One macro concern is that major banks overly tighten credit (typically viaincreased policy rates), thereby limiting or reversing some of the recenteconomic momentum. While on the surface the impact would probably beshort-term bearish for commodities through the demand channel, over thelonger term rising rates could paradoxically sow seeds for improvedbalances by increasing the cost of capital and reducing investment.
Overall we see a broadly positive outlook for commodities in the next year.Supply-side adjustments, a reasonably positive outlook for global economicactivity and firm commodity demand all point to improving fundamentals.With inflation risk rising and the return of commodities as a diversifierfor portfolios, we think portfolio allocations that are in line withbenchmark allocations or modestly overweight may make sense for mostinvestors.