Equities: New extremes and a challenging opportunity set
Discover insights on the future of equity markets in Q1 2024 and navigate the potential recession with strategic investment choices.
We expect the broad commodity rally that saw the Bloomberg Commodity Index rise by 10% during the last quarter to extend further into 2021. This will be driven by multiple tailwinds from tightening supply and a global market flushed with cash, driving speculation across markets and increased demand for inflation hedges. Add to this the prospect for a weaker dollar, a vaccine-led recovery in global demand and emerging weather worries, and the components for another commodity super-cycle have started to materialise.
All of this is happening during a time when the pandemic is still raging across many countries, especially in winter-hit regions across the northern hemisphere where the prospect for improvement, vaccine or not, is unlikely to occur until warmer weather arrives in March and April. While the rally may pause until the vaccine rollout gathers momentum, the market will have to rely on continued investment demand being strong enough to keep markets supported during the coming months where the negative impact of lockdowns and reduced mobility will be the greatest.
The strong rally at the backend of last year saw the Bloomberg Commodity Index break the downtrend from 2011.
A combination of factors will continue to support the sector in 2021. This include a weaker dollar, increased demand for inflation hedges and a pickup in fuel demand as global mobility recovers, as well as the green transformation driving demand for key industrial metals from copper to silver, and rising demand outside China as governments go on a spending spree to support jobs. Despite the prospect of rising US bond yields, precious metals are likely to maintain a bid in response to the weaker dollar and rising inflation expectations. Adding to these is the risk of elevated food prices as the weather becomes more volatile, something highlighted by the recent surge in corn and soybeans to a seven-year high.
One of the main obstacles for a commodity rally during the past decade has been the ample availability of raw materials. Oversupply during the past decade and especially during the past six years kept the commodity sector as a whole in a state of contango where the spot price, due to ample availability, traded cheaper than deferred prices.
From 2014 until last quarter, a portfolio of major commodities carried a negative roll yield which at times was as high as 5% on an annual basis. From an investment perspective, this headwind combined with a generally strong dollar and low inflation reduced the attraction for commodities.
In recent months however, the roll yield on several commodities has risen strongly, resulting in the average on the 25 commodities (excluding natural gas) rising to 2%, a seven-year high. As the chart below shows, the change so far has been led by the agriculture sector, where key crops have rallied strongly in response to lower weather-related production and rising demand.
In 2021 the expected pickup in demand, as well as the reflation theme, look set to underpin the sector, especially in markets where supply may struggle to meet demand. We are focusing on copper, platinum, soybeans and eventually also crude oil, to mention a few.
From an investment perspective an exposure to the commodity sector can be achieved through ETFs or CFDs tracking the major indices. Please note that some regional restrictions apply with regard to the availability of products relative to your investment status, either as a retail or professional investor.
The chart below shows the composition of two major commodity indices which are tracked by many different ETFs. The S&P GSCI and the Bloomberg Commodity Index spread their exposure across 24 and 23 futures contracts respectively, within the three main sectors of energy, metals and agriculture.
Note that a preference for energy should be expressed through ETFs tracking the S&P GSCI Index, which is energy heavy (54%); ticker examples include GSG:arcx and GSP:arcx. A general protection against inflation and the emergence of positive roll yields in agriculture may best be achieved through the Bloomberg Commodity Index, due to a greater diversification and a smaller exposure to energy, which still has a low-to-negative carry; ticker examples include CMOD:xlon and DJP:arcx.
Energy: Crude oil’s strong vaccine-led rally since early November has taken Brent crude oil back above $50/b, and unless we see another sharp reduction in global fuel demand during the current quarter, the foundation for higher prices later in the year has been established. This is not least after Saudi Arabia unilaterally decided to cut production in February and March in order to support the market during a potentially challenging period of lockdowns and reduced mobility.
Fundamental indicators look healthy with backwardation emerging in both Brent and WTI, as OPEC+ keep supplies tight before mobility restrictions are expected to be lifted globally later this year. However, before a potential worry about where the next barrel of oil is going to come from, we first need to see the removal of global spare capacity held by OPEC and Non-OPEC producers, estimated to be around 7.5 million barrels/day.
With global oil demand still running close to 6 million barrels/day below pre-pandemic levels, we do not see a material upside risk to oil prices before 2022 or even 2023, at which point the dramatic cut in capex from global oil majors may start to impact the ability to find new barrels. On that basis we see Brent crude oil trading steady in the mid to low 50s during the quarter, until the point where fundamentals are strong enough to support an extension towards $65/b.
Precious metals: Gold and silver witnessed a strong start to 2021, before rising US bond yields and the resulting stronger dollar took some of the shine out of both metals. Despite this we maintain a constructive view on the sector with rising yields being primarily the result of a gold-supportive rise in inflation expectations; this will leave real yields, a key driver for gold, well into negative territory. Together with accommodative central bank policies and renewed dollar weakness, the path of least resistance remains to the upside. In addition, the incoming Biden administration is likely to embark on a spending spree in order to rebuild a pandemic-hit economy.
The vaccine rollout will undoubtedly act as a headwind given the prospect of an economic revival, but with central banks signalling low rates for longer it only raises the risk of a policy mistake adding further fuel to the inflation engine.
Silver has returned to its long-term value against gold with the prospect of a further upside depending on the strength of both industrial and investment demand. The green transformation could spark a surprise in terms of industrial demand with the photovoltaic (PV) market expected to be strong as many countries embark on renewable energy projects. Based on our forecast for gold to reach $2200/oz, silver’s high beta should encourage a continued outperformance with the gold-silver ratio heading towards the low 60s during 2021, thereby driving the price of silver towards $35/oz.
Agriculture: Weather permitting, the agriculture sector in 2021 should see a major response from farmers in terms of increased supply following the surge in prices during the past six months. While it can take years for oil producers and mining companies to raise production in response to higher prices, farmers have the ability to respond from one season to the next.
With corn and soybeans reaching seven-year highs at the start of 2021, the prospect for a major response – again weather permitting – from farmers in key growing may limit the upside as we approach the US planting season. Add to this a speculative long in corn and soybeans at levels not seen since 2012, and we expect increased volatility and risk of corrections over the coming months. Overall however, we see unpredictable weather developments, strong Chinese demand and the prospect for a weaker dollar as key tailwinds that will continue to underpin the agriculture sector as a whole.
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