Cross Asset Strategy
Central banks and rates have continued to take center stage over the past week. Policy actions from the FOMC meeting were largely in line with market expectations; a 50bps hike, and Quantitative Tightening to start in June. Powell’s tone from the press conference was less hawkish than expected by some – and notable takeaways include 1) 75bps hikes were taken off the table, and 2) the Fed is non-committal about raising rates above the “neutral” level. Fears over Fed hawkishness moderated. Ten-year yields have gone back to below 3%, and the market implied terminal rate went down from 3.4% to around 3% after moving almost 200bps higher over the past two months. Risk assets rebounded and the S&P 500 rallied 3%. We’ll be watching Fed speak over coming weeks as it’s likely a Fed, which is trying to tighten financial conditions, might not like being seen as “dovish.”
Elsewhere in the world, India unexpectedly raised rates by 40bps, sending the country’s government bond yields to a three-year high. The move highlighted policymaker concerns over inflation and signaled their clear priority to fight against inflation versus supporting growth. It’s also become clear that we are entering a synchronized tightening cycle and it will be a global challenge for central banks to engineer a soft landing. At this stage we are staying selective in equities – focusing on quality names, and favoring core fixed income for protection.
It’s also been an eventful week in the commodity world. On Wednesday the EU stepped up its sanctions on Russia with a move to ban oil imports. All EU member states will need to phase out Russian oil in the next six months, with the exceptions being Hungary and Slovakia. It will undoubtedly be a tough transition for many European economies and should add another layer of support to elevated oil prices (which rallied over 3% on the news). We have been recommending commodities as a hedge against inflation and geopolitical risk for some time, and continue to favor the trade. Read on for details on why we think the commodity bull run could continue.
Strategy Question: Can commodities rise higher?
Commodities as measured by the Bloomberg Commodity Index (BCOM), gained 50% over the last 12 months and is up 32% YTD. The correlation with inflation – whether as a driver or consequence – has helped insulate portfolios in an inflationary regime and has also provided good diversification in portfolios in 2022.
The main drivers of the price appreciation have been supply chain issues, including production, shipping, hoarding and inventories, plus a faster than anticipated pandemic recovery. Other factors include growing ESG investments redirecting capital away from traditional energy sources, and also war. The mix may change in the years ahead, but the trajectory will likely be sustainable.
The BCOM Index is comprised of 23 commodities across six different sectors. It is investable and there are a number of vehicles that track or actively attempt to replicate or even beat the Index. The challenge in forecasting such a diverse index is formidable. In an attempt to provide wider guidance to our clients we will be periodically issuing an outlook of the expected trading range for the index over the next 12 months. With the caveat that the course of the Russia-Ukraine war could significantly change our expectations, we expect the BCOM Index to appreciate 10-15% over the next 12 months to 143-153.
Gold
The precious metals – and especially gold – are highly emotional investments. Over the years we’ve learnt that investors can become very attached to investments in gold. This year has shown the trend in an extreme form, as the emotional premium in gold has moved to its highest ever level. Why do we say that? Because most analysts apply a fundamental framework to the valuation of a commodity. In the case of gold, it is commonly a combination of real interest rates and the US Dollar. Those models currently value gold at a $300 discount to the current price. The emotional premium is very hard to forecast, as it reflects a combination of human feelings, but a number of reasons can explain why investors are currently buying the metal:
- Early signs of social unrest in Emerging Markets. There is a potential humanitarian crisis as food prices surge. Covid lockdowns in China can be included within this point.
- The Ukraine war
- High inflation
- A commodity bull run is lifting all boats
- There are bullish technical factors
- The diversification benefits given bonds and equities aren’t working
- Retail flows are strong.
These reasons, or a combination of them, could persist for many more years, and consequently we are revising our outlook for the metal higher for the next 12 months, but likely with less dramatic movement than in recent months. Real interest rates will likely eventually push the attraction of gold lower – and we see it losing some of its record emotional premium to trade at a range of $1875-$1975 in the 2Q of 2023.
Crude Oil
It is an unfortunate reality that we currently live in a world that isn’t quite ready to transition away from fossil fuels. This is causing quite a struggle between environmentalists on the one hand, and fossil fuel realists and producers on the other hand. The war in Ukraine has only served to exacerbate the struggle, as countries seek to avoid Russian oil and source supply from alternative sources. This dynamic emerged in a market that was already tightly balanced between supply and demand.
At the risk of infuriating environmentalists and progressive Democrats, the current U.S. administration finds itself in a very difficult balancing act – trying to boost US production growth and infrastructure builds at the same time as pursuing a foreign policy agenda that limits the ability to source oil from perceived bad actors. This is unsustainable and something has to give. The argument that the solution is to move away from fossil fuels is correct, but unfortunately tanks, fighter jets and battleships can’t currently run on solar, wind or hydro power. So until the day dawns where we either discover game-changing sustainable energy sources (Oxford scientists are claiming progress in nuclear fusion), or we find a way to electrify our militaries and transportation, the global economy will likely continue to look to oil to power the world.
This will not stop governments and investors from attempting to find a solution by directing capital away from fossil fuels towards renewables and sustainability. Nor should it. We too dream of a world free of reliance on dirty energy.
As we all wait for that day, Crude Oil will likely continue to stay supported and we are increasing our WTI expectations to a new range of $93-$103 over the next twelve months. Crude volatility is hovering around 40% for a 25 delta option and therefore we would add a potential spike possibility to $150 in the event that Russian Oil becomes harder to source.
Natural gas
Natural Gas follows the same script, but it is cleaner and can be supercooled to create Liquified Natural Gas (LNG). This U.S. source has become very attractive to European countries as they attempt to move away from Russian supplies. President Biden recently announced the US will commit to ship an extra 50 billion cubic meters of LNG annually to 2030. This will likely support U.S. Natural Gas prices and we are expecting an increase over the next 12 months to $7.00 – 7.75 We don’t feel comfortable attempting to project a price for European Gas TTF, as the variables are too many to have even a small level of conviction.
Agricultural Commodities
Finally we turn to the agriculture complex. Food inflation is indeed a new reality across many parts of the world. There is a steady trickle of enquiries around the subject and there are ways to invest in the theme. Sadly, aside from the loss of supply from Ukraine, further stresses are emerging as a result of farming issues caused by rising costs. One of the biggest problems is increasing fertilizer costs, increasingly expensive diesel fuel that powers machinery, low propane stocks to dry grains and a chronic shortage of spare parts. We expect prices to go higher over the next 12 months. Wheat should trade to 1200-1300 and Corn to 875-975.
All market and economic data as of May 5, 2022 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.
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Indices are not investment products and may not be considered for investment.
RISK CONSIDERATIONS
- Past performance is not indicative of future results. You may not invest directly in an index.
- The prices and rates of return are indicative as they may vary over time based on market conditions.
- Additional risk considerations exist for all strategies.
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Index definition:
Bloomberg Finance L.P. Commodity Index is a benchmark designed to provide liquid and diversified exposure to physical commodities via futures contracts.
Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.
Past performance is not a guarantee of future returns and investors may get back less than the amount invested. It is not possible to invest directly in an index.
