Commodities strike back

In the latest instalment of Simply Put, we explore whether the recent strong performance of commodities is sustainable and whether there is still time for investors to benefit.   

Commodities have recently experienced a period of growth and increased volatility. This is a rather unusual situation in the history of these markets and raises a key investment question: is there still time to gain exposure to commodities? The answer is twofold: commodity prices could still rise (demand remains strong and supply disrupted) and investors could also benefit from an abnormally high carry.  This second point could make a real difference in the coming months.

Let's first look at the mechanics of the commodity risk premium. Typically, demand plays a more important role than supply in commodity markets. Periods of growth, and thus of strong cyclical demand, tend to correspond to periods of rising cyclical commodity prices. In contrast, a contraction in demand resulting from a recession, for example, usually leads to a contraction in demand for commodities as well as a collapse in prices. In statistical terms, this leads the returns for most cyclical commodity markets to be characterised by a left skew. Statisticians refer to this as a “negative skewness”, as strongly negative returns occur more frequently than strongly positive ones. Academics tend to agree that a risk premium can be characterised by negative skewness. Another important element is that downturns are usually accompanied by increased volatility, so that returns and volatility are negatively correlated. In short, commodities are indeed a risk premium in this respect, as shown in Chart 1.

Chart 1. Skew and risk/return correlation among commodity markets

Source: LOIM. Bloomberg. 1900-2022.

2022 may be giving the impression of a very different situation: strong demand combined with supply disruptions, following the pandemic and the Russian invasion of Ukraine, have generated a prolonged run of positive commodity returns. Yet commodity skewness has not become less negative – quite the contrary. The negative correlation between returns and volatility has grown. From this point of view, 2022 is characterised by an increase in the risk markers for any risk premium. The most logical consequence of this situation is a bigger commodity risk premium – investors should therefore expect to be compensated more for taking this risk through their carry. Yet, is this the case?

The combination of heightened commodities risk and the nature of this recent shock to commodities – a supply shock – has led to an increase in the usual carry for commodities. The disruption of supply has resulted in a significant part of the price increase taking place at the short end of the futures curve. For example, during 2022 the first futures contract for West Texas Intermediate (WTI) rose from $71 to $107 (reaching as high as $120), while the sixth contract only rose from $69 to $98 per barrel, i.e., an increase differential of 12%.  This phenomenon is not limited to the oil market but has spread to a very large number of commodities, as shown in Chart 2. Our analysis over the period 1990-2022 shows that 80% of commodity markets are currently in backwardation (when the current price of the underlying asset is higher than the price in the futures market), with a carry of around 10%. This level of carry may only have been exceeded 3% of the time during the period covered, but the percentage of the market in backwardation has been unprecedented. In our view, the carry of the asset class has largely aligned with the risk attached to it this year, suggesting commodities investors should continue to be rewarded for their exposure, this time through the increased carry associated with it. In a nutshell: the story of commodities is far from over, at least that is what market pricing seems to indicate.

Chart 2. Percentage of commodity markets in backwardation

Source: LOIM. Bloomberg. 1900-2022

Macro/Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

On the macro front, the news flow coming from Europe and China has been muted. In the US, the statistics are unanimous: US growth is strong. Private economists are now expecting 2022 growth to reach 3.2%, a high number given its recent range. The Federal Reserve Bank of Philadelphia’s outlook survey was 17.6 versus 21.4 expected and 27.4 in March: while it declined, this drop remained consistent with high growth. The leading index also fell from its highs of 2021 but pointed to a US economy on track with its potential at least (about 1.8%). This week’s housing data also showed signs of strength: housing starts remained strong while new home sales were still on an expanding path. The combination of all of these elements explains the growing confidence of the Federal Reserve in asserting its hawkish monetary policy. Not only are economic data strong: surprise indices for the US economy are positive and higher than their level at the end of 2019. This may come as a surprise to those discounting the negative impact from the combined commodity and monetary policy shock. The future of US growth keeps on dividing economists as charted below: when looking at the pool of economists forming the consensus available on Bloomberg, the spread between the minimum and maximum forecasts has progressively widened throughout the year. Interestingly, even the lowest of these forecasts (0.3%) currently does not foresee a recession: 2022 could be the first soft landing ever engineered by central banks.

Factoring in these new data points, our nowcasting indicators currently point to:

• Still solid worldwide growth. The US and the Eurozone are showing solid numbers, while China remains set on a deteriorating path.
• Inflation surprises should remain positive, but our signals have shown a recent decline. This decline follows the recent moderation of commodity prices, but not just this: 70% of the data constituting our inflation gauge is now declining.
• Monetary policy is set to remain on the hawkish side, mirroring the strength of activity .

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gathers economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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