- Commodities have outperformed equities as inflation rises
- Crude oil leads the price rally in commodities, rising 48% so far this year
- Commodities are rallying despite a strengthening dollar
- Expected slowdown in global growth clouds demand scenario for 2023
Commodities have rallied this year, outperforming equities and underscoring their credentials as a hedge against rising inflation and as a portfolio diversifier at a time when investors are debating if the world’s largest economy can avoid tripping into a recession as the Federal Reserve (Fed) raises interest rates.
The S&P GSCI, a composite of 24 commodities representing sectors from energy to agriculture and livestock to metals, has surged 34 since the start of 2022, and is up 213% from its 2020 low during the pandemic, while the CRB Index, which consists of 19 commodities including crude oil, gold and corn, is up about 37% this year, and is up nearly 200% from its 2020 low.
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By contrast, the S&P 500 has had a -22.5% year-to-date total return as of June 16 and is down by about 12% from a year ago. The tech-heavy Nasdaq-100 is down 31% from the beginning of 2022 and down 4% from a year ago (Figures 1 and 2).
Figure 1: Contrasting performance of CRB Index and S&P 500 Equities
Figure 2: Commodities outperform as the Nasdaq-100 retreats
Leading the rally in commodities has been oil, with WTI crude oil surging 48% this year due largely to Russia’s invasion of Ukraine and the subsequent sanctions on Russian oil exports by the U.S. and Europe. WTI crude oil also broke above $120 per barrel amid tight global supplies even as OPEC+ decided in June to raise output by 648,000 barrels per day in July and August when the summer driving season in the U.S. will be in high gear.
Natural gas prices have also risen substantially, up more than 81% this year boosted by strong demand, exports from the U.S. and relatively low inventories. The invasion of Ukraine also impacted prices for agricultural commodities such as wheat and corn, which have surged about 100% from their 2020 lows. Lithium, used in the production of batteries for electric cars, has soared 71% this year as the gains in crude oil prices and growing concerns over climate change accelerate the demand for electric vehicles.
Commodities as an inflation hedge
The rise in these commodities have underlying fundamental reasons such as supply disruptions caused by Russia’s invasion of Ukraine, supply chain issues caused by the pandemic, inclement weather conditions in Brazil supporting soybean prices and seasonal increases in demand such as for gasoline during the summer months in the northern hemisphere, adding to inflationary pressures.
The phenomenon of rising inflation has increasingly become a global phenomenon in major economies except for a handful of nations such as China and Japan. Inflation in the U.S. is at the highest level in 40 years, topping 8% (Figure 3) while hitting a record high 8.1% in Europe in May. In the U.K., inflation has soared to 9%, 17.8% in Russia, and an astonishing 73% in Turkey due largely to shortages caused by supply chain challenges triggered during the pandemic and a shift in consumer demand to manufactured goods from services during social sequestration as a safety measure.
Figure 3: Inflation has been climbing since May 2021
The Fed has already raised rates three times in quick succession, while signaling that more increases are on their way as the central bank makes reining in inflation its top priority as indicated by Fed Chair Jerome Powell. The European Central Bank’s President Christine Lagarde has said the central bank could raise interest rates in July by 25bps while hinting at a 50 bps rate rise in September, and exit negative rates by the end of the third quarter.
Commodities are considered a hedge against inflation due to their intrinsic value and tend to perform well when prices for consumer goods are on the rise, while equities tend to perform poorly when high inflation leads to increases in interest rates, which tend to decrease the value of cash flows in the future for companies due to the effects of inflation. Research by Vanguard points out that over the last decade, commodities rose by 7% to 9% for every 1% of unexpected inflation (the difference between projected and realized inflation) experienced by the economy. However, many commodities, especially natural gas, and to a lesser extent crude oil and agricultural goods, can incur significant storage costs, which can make them difficult to hold over long periods of time.
Until late October 2021, investors hardly showed any concern about inflation in the U.S., with the Fed initially adopting the stance that the rise in consumer prices that began in April of 2021 was transitory. Now, the big question is for how long inflation might stick around at above the Fed’s target rate of two percent.
Commodities tend to have a low correlation to stocks and bonds, which can attract investors looking for diversification. This rational can be enhanced during periods of rising inflation as investors may see commodities as a way to diversify portfolios
The rise in prices for a range of commodities comes despite a sharp strengthening of the U.S. dollar against a basket of six currencies, rising to two-decade highs against the Japanese yen, and multi-month highs against the euro, British pound and the Chinese yuan (Figure 4). Commodities and the U.S. dollar typically have an inverse relationship as the greenback is the preferred currency in the global commodities trade.
Figure 4: The dollar typically has an inverse relationship with commodities
Since commodities are usually quoted in USD terms, normally a stronger dollar implies weaker commodity prices but the past 12 months have been an exception as inflation has driven both commodity prices higher alongside the U.S. dollar versus foreign currencies. The dollar rally appears to be due, in part, to the fact that the Fed is moving more quickly to tighten policy than the European Central Bank (ECB), and especially the Bank of Japan and the People’s Bank of China, both of whom are still easing policy. But this is beginning to change, at least in Europe where the ECB, which just months ago was resisting any change to its easy monetary policy, has signaled that rate hikes might be coming this summer.
China is a major consumer of a range of commodities, from oil to copper to grains, and its demand tends to underpin prices. And, this relationship was illustrated during the start of the pandemic in late 2019. The GSCI fell from 2,995 on Jan 3, 2020 to 1,706 by April 28 as the world’s second largest economy was hamstrung by widespread lockdowns to contain the disease from spreading. The stringent measures adopted by China helped the country to bounce back, becoming one of the first economies to recover from the pandemic. The GSCI bottomed out at the end of April 2020 and began climbing to its current high around 4,236, propelled further in recent months by the Russian invasion of Ukraine. China’s currency has broken out of its narrow trading range against the dollar, weakening like other currencies against the greenback (Figure 5).
Figure 5: Chinese yuan has broken out of its range with the dollar
A renewed outbreak of Covid in China earlier this year that led to travel restrictions and the shutting down of businesses in major cities like Shanghai saw the index drop about 1,000 points amid concerns that Chinese demand for commodities might be dented, but the removal of some of those restrictions led to the index bouncing back in May. But there might be more concerns on the horizon with the World Bank expecting China’s growth to slow down to 4.3% this year from 8.1% in 2021. In fact, on a broader context, the bank has projected global growth to slow to 2.9% in 2022 from 5.7% last year – if this materializes, it could be a downdraft for commodities.
Is the surge in commodity prices the start of a new supercycle, a prolonged period of gains stretching through a decade, or is just a fundamental or technical run up in prices due to circumstances including the supply disruptions caused by the Ukraine war? The last such supercycle through the 2000s was fueled by the economic expansion of China which supercharged demand for a range of commodities as the country laid the groundwork to become the world’s second largest economy. This was supported by the economic rise of Brazil, Russia and India, as part of the BRIC nations that includes China, that added to the growth in demand for commodities. This time around, the rise in commodities seems to be predicated on supply chain disruptions caused by the pandemic and the war in Ukraine, both of which could become less of a factor with time. Also, expectations for a slowdown in global growth could also impact the surge in commodity prices, if the outlook proves to be correct. Futures’ forward curves for many of these commodities are showing lower than current prices. Oil, which is trading at around $120 per barrel in June, was priced at around $97 one year out. Similarly, Kansas City wheat was currently trading at around $11.56 per bushel, but two years out, it was being priced at around $9.50. The price outlook is a reflection of current investor sentiment and could change based on circumstances. Another factor in the supercycle equation is how long the dollar’s strength – which typically correlates inversely with commodity prices – could be sustained by inflation and higher rates.
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