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December 2018

Digging deep: The outlook for commodities

Christopher Dhanraj
Director
Head of iShares Investment Strategy

Commodities are experiencing volatility, but investors should not overlook the role they can play in a portfolio.

Key points:

  • Until recently, commodities had been among the best performing assets this year, but the fourth quarter selloff has seen a bear market emerge in the asset class, led lower by crude oil.
  • The current strong growth, rising inflation regime has historically benefited commodities and could provide potential support to the sector in the late stages of the current economic cycle.
  • From a portfolio perspective, we consider that commodities can provide meaningful diversification and inflation hedging benefits.

Commodities in 2018

Commodities have performed well at stages in 2018, as strength in oil prices outweighed cooling industrial metal demand. However, October’s selloff in oil was balanced by a rally in precious metals like gold and silver, which served their classic role as diversifying perceived “safe havens.”

The medium term outlook for commodities looks challenging. Crude oil, a key component of broad commodity benchmarks, with a 42% weight in the S&P GSCI Index, has slipped into a bear market.1 Energy supply and demand dynamics, once supportive, have worsened in the face of responses to U.S. sanctions and negotiations with the Organization of Petroleum Exporting Countries (OPEC). Inventories across industrial metals are relatively depleted after the global post-crisis recovery, which could be favorable if global growth beats expectations. Below, we look at three key sub-components of the popular S&P GSCI Index and potential drivers of their performance.

Figure 1: Year to date performance of individual commodity markets

Figure 1: Year to date performance of individual commodity markets

Source: Thomson Reuters, S&P and BlackRock Investment Institute as of Nov 30th, 2018.

Notes: The bars show the year-to-date performance of individual commodities in the S&P GSCI index

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

Energy: From 2016 to October of this year, crude oil rallied behind normalizing OPEC production levels, multiple years of global economic expansion, and upside price shocks delivered by geopolitical developments. The West Texas Intermediate (WTI) benchmark rose from a low of $26/bbl in 2016 to $75/bbl on October 3rd.2 However, WTI fell 33% from October 3rd to November 30th amid concerns over supply, weakening demand, and other technical selling factors.

However, we believe the selloff to be overdone. Production appears set to decline based on recent OPEC negotiations, we believe, which could boost prices. Consider, for example, how Brent crude rallied 9% on November 30th, 2016 after OPEC and other oil exporting nations announced a 1.8 million barrel-per-day production cut. The agreement contributed to an increase in the trading range of the commodity, and Brent prices rose from an average of $45/bbl in 2016 to $55/bbl in 2017. Elsewhere, the fact that Iranian sanction waivers are set to expire could also limit global production levels and serve as a boon for prices.3

Additionally, energy demand is anticipated to exceed supply in 2019. Moreover, geopolitical tensions between the U.S., Saudi Arabia and Iran could be catalysts for higher prices, although those are difficult to forecast, it is important for investors to monitor how these tensions translate into global production levels.

Figure 2: World oil demand is expected to surpass supply into 2019

Figure 2: World oil demand is expected to surpass supply into 2019

Source: Thomson Reuters DataStream, Oxford Economics, BlackRock Investment Institute. As of Nov 19th, 2018. Notes: Forecast from Oxford Economics. There is no guarantee that the forecast will come to pass.

Industrial metals: Metals prices — namely copper, aluminum, nickel and zinc — have fallen this year as a strengthening dollar and a rise in real yields have eroded their attractiveness. Within industrial metals, however, supply and demand dynamics may be supportive of prices going forward: Supply has tightened considerably after years of expansion, while strong growth may boost demand and prices, if it continues to surprise to the upside.

Precious metals: Precious metals have had a relatively poor year but performed well in the recent equity market volatility. Rising macro uncertainty has impacted both equity and bond prices, but dollar strength and rising real rates meant that gold saw little investor interest as a perceived safe haven for most of the year. However, amid a stable dollar, gold and silver played their perceived safe haven roles when investor risk appetite capitulated.

Supportive macroeconomic environment

Despite the recent volatility, we believe the current economic regime remains supportive for commodities. According to forecasts amalgamated by Consensus Economics, there is a potential for higher inflation and growth in 2019. This has historically been favorable for the asset class. Figure 3 identifies how in years with above average U.S. GDP growth and inflation, the average return of the S&P GSCI Index has numbered 18.4%.

Figure 3: Commodities have historical performed well in high growth, high inflation regimes

Figure 3: Commodities have historical performed well in high growth, high inflation regimes

Source: BlackRock, Bloomberg, as of Nov 30th, 2018.

Notes: The table shows how commodities perform in different regimes of economic growth and inflation from 1991 — 2017. “Growth” is measured by U.S. annual GDP growth. “Inflation” is measured by the YoY change in U.S. headline CPI. Note that “high” is defined as above average, while “low” is defined as below average. The average annual GDP growth over the 33 year period was 2.8% while YoY CPI was 2.7%. Period covered is 4/30/91 to 12/31/17.

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

Additionally, we note that historically, commodities have performed well late in the economic cycle. Figure 4 quantifies “late-cycle” as when unemployment is below the Non-Accelerating Inflation Rate of Unemployment (NAIRU), often used to represent an equilibrium between the state of the economy and labor market. As the graphic depicts, the S&P GSCI Index has averaged a 4.5% return in quarters of late-cycle economic dynamics.

Figure 4: Commodities have historically outperformed in the late-cycle economy

Figure 4: Commodities have historically outperformed in the late-cycle economy

Source: Thomson Reuters, Federal Reserve, BlackRock, as of Nov 30th, 2018.

Notes: Cycle definitions are based on the quarterly levels of U.S. unemployment in relation to the Non-Accelerating Inflation Rate of Unemployment (NAIRU), often used to represent an equilibrium between the state of the economy and labor market. Early cycle is defined as quarters with unemployment above NAIRU, while late cycle is when unemployment is below. Period covered is 4/30/91 to 12/31/17.

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

However, it must be noted that rising global protectionism raises the potential for a wider range of macro outcomes going forward, as seen by a greater array of global growth forecasts from economists. This paints a potentially challenging picture for commodity prices. The direction of the U.S. dollar also will be vital to monitor; historically, a stronger dollar has been detrimental to commodities.

Commodities in a portfolio

Though tactical investing in commodities can be challenging, it is important to remember the longer term case for commodities in a portfolio, namely diversification and inflation protection.

Inflation protection. In periods of above average nominal inflation, the dollar tends to depreciate. This means it requires more dollars to purchase a specific commodity. Figure 3 highlights how the S&P GSCI index and its major components have performed in different annual regimes of growth and inflation, with gains in cyclical commodities outperforming precious metals.

Diversification. Given the varied drivers of commodity prices, commodities tend to have a lower correlation to other major asset classes, bringing potential diversification benefits to multi-asset investors. For example, from 1991-2018, the quarterly returns of the S&P GSCI Index have had just a -0.16 correlation to the Bloomberg Barclays U.S. Aggregate Index and a 0.38 correlation to the S&P 500 Index.4

Investor positioning

ETP investors steadily added assets to commodity exposures over the first few months of the year, culminating in over $2 billion of net inflows in April before the trend turned to significant outflows of over $5 billion between May and August 2018 (see Figure 5). Investors now appear to be regaining appetite for commodity exposure, with $769 million flowing into ETPs tracking the asset class in October, and $817 million in November.

Figure 5: Total U.S.-listed commodity ETP flows, past 12 months

Figure 5: Total U.S.-listed commodity ETP flows, past 12 months

Source: BlackRock, Nov 30, 2018. Notes: The November data was as of market close 11/29. ETP groupings and categories are determined by BlackRock.

The bottom line

The current economic regime of robust growth and rising inflation has historically been supportive of commodities, and we believe this regime is likely to continue. We find that oil prices are near their bottom which could serve a potential entry point for commodity investors.

Other parts of the commodity market have demonstrated their attractiveness. For example, in the recent equity market volatility, precious metals have played their traditional role as perceived safe havens.

Over the longer term, commodities can potentially add diversification and inflation hedging characteristics to a portfolio.