Commodity markets enter the new year having taken it on the chin, effectively giving back the prior two years’ worth of hard-fought gains in a matter of mere months as the world’s two heavyweights—the US and China—traded punches in the fight over free trade. The US Federal Reserve piled on, with strong domestic growth and somewhat tame inflation encouraging it to raise its target federal funds rate four times in 2018. This made the US dollar irresistible to yield-hungry global capital and landed a haymaker across the jaw of an already shaken commodity market.
So what’s the outlook for commodities in 2019? Let’s review a few risks and opportunities that could set the stage for an early knockout or a late-round comeback for this beaten-up asset class.
The US-China trade war
It’s been nearly a year since President Trump threw the first public jab in this brawl, and a long year it’s been for many in the agriculture and metals markets, where tariffs have cut deepest. In total the US has imposed tariffs on $250 billion of imports, and China has retaliated with levies on $110 billion worth of US exports.
Many analysts agree that the greatest pain is likely to be felt this year, with a slowdown in China’s exports possibly shaving more than 1% off that country’s real GDP growth, according to estimates from Citigroup. It hits at a time when China’s economy is already facing a slowdown. A 90-day truce announced in early December has many hoping that a longer-term solution can be reached, which would likely lift commodity prices broadly, since China would begin importing a significantly greater amount across the commodity spectrum.
The near-term outcome notwithstanding, the risks appear more asymmetric to the upside, since the swift market reaction that took place after the onslaught of tariff rhetoric has already priced in the ongoing stalemate between the sides. Any resolution before the March 1 truce deadline will be welcome news and should give the asset class some respite from the beating it’s been taking.
The US dollar
The dollar tends to be commodity performance’s evil twin. When it falls, commodity prices tend to rise, all else equal, with the reverse occurring during periods of dollar strength. One explanation for this is that when the dollar depreciates, goods priced in dollars become less expensive abroad, causing demand to rise. And vice versa during periods of dollar appreciation. The graph below, which compares the US Dollar Index (DXY) with the S&P GSCI, a common benchmark index for commodity performance, neatly illustrates this.
Sources: S&P Dow Jones Indices, Intercontinental Exchange, 12/31/18
As you can see, the dollar fell nearly 10% in 2017 after rising for the prior four years, and it looked like the slide was going to continue in 2018, with the DXY declining 2.33% over the first quarter. However, as it became apparent that the Fed would continue hiking rates (for a total of four times in 2018) and the synchronous global growth we’d been experiencing was getting out of sync, the dollar had the support it needed to continue its grind higher, resuming its pummeling of commodity prices.
Yet that may all be about to change as we enter 2019, with a few emerging risks that may begin to weigh on the dollar. For one thing, a rise in equity volatility and concerns over US growth have pressured the Fed into taking a wait-and-see approach on implementing any further rate hikes, potentially allowing the rest of the developed world to play catch-up and normalize their monetary policy. And to the extent rates do increase outside the US, dollar depreciation may again be the path of least resistance, since marginal flows into the country may begin to reverse.
Another risk facing the dollar this year comes in the form of a one-two punch, in what many economists describe as the twin deficits. In a nutshell, this is when an economy runs both a budget deficit and a current account deficit, which can cause strong currency devaluations as government borrowing ends up being funded by an increase in the trade deficit.
Sources: Federal Reserve, Federal Reserve Bank of St. Louis, US Office of Management and Budget, Bloomberg, 12/31/18
If this hypothesis is even partially correct, persistent US deficits may begin to weigh more heavily on the dollar, especially as government revenues begin to feel the full effect of last year’s tax cuts. This could be a positive development for commodity prices. And even if dollar weakness doesn’t materialize as many think it will this year, a mere sideways dollar should give commodity prices enough breathing room to move higher.
The cure for low commodity prices
It’s often said that the cure for low prices is low prices. And while that may not be true in the strictest economic sense, low prices do tend to promote consumption and reduce capital expenditures and resource allocation by companies, thus reducing future supply. The result tends to be a more fundamentally balanced market in the near to medium term, with the potential for higher commodity prices as the market tightens.
As of the end of 2018, commodities across the spectrum were largely trading at or below their respective average over the prior three years, with the average discount near 5%. Historically, when prices have fallen to around this mark, the return over the next year proved to be fairly strong, on average, coming in at roughly 7%. The graph below shows the current dispersion across the asset class, measuring the discount or premium for each commodity along with the average return over the next year when prices have fallen to around these levels.
Sources: CME Group, Intercontinental Exchange, Bloomberg, 12/31/18
The bottom line
Commodities enter 2019 having been beaten up by multiple foes. And while this has some wavering in their commitment to the asset class, we argue that much of the damage may have already been done, with risks now more prominently positioned to the upside from a macro perspective. While idiosyncratic risks may still be present, reducing those through broad diversification is the only surefire way to capture the expected benefits of the asset class and avoid the repeated blows a concentrated portfolio can deliver.
Greg Liebl, CFA - Portfolio Manager
Mr. Liebl is responsible for all Parametric proprietary and non-discretionary commodity strategies in the Minneapolis Investment Center. Since joining Parametric in 2010*, Greg has provided Portfolio Management in the areas of risk and exposure management and customized implementation solutions.
*Reflects the year employee was hired by The Clifton Group, which was acquired by Parametric Portfolio Associates® LLC on December 31, 2012.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.