An allocation to commodities is sometimes considered for building portfolios in times of high inflation. However, they are a volatile asset class, says Evan Brown, head multi-asset at UBS Asset Management. Today’s negative market sentiment doesn’t reflect the underlying fundamentals, he writes in his latest Macro Monthly.
However, these assets are also highly volatile and have suffered a substantial drawdown in recent weeks. According to Brown have these market been exacerbated by a large fall in speculative positioning amid increased concern about a future recession. “Now that speculative positioning has been curbed, the current fundamental drivers of the market can reassert themselves. Commodity markets are generally much less forward-looking than stocks and longer-term bonds, since they reflect current supply/demand conditions. As such, these exposures may perform well in a late-cycle environment where demand is slowing, but positive – so long as supply remains limited. That is the backdrop we expect will prevail over the near term, particularly for energylinked assets. We believe pullbacks are likely to be buying opportunities so long as the onset of a recession is not imminent.”
And in the medium term, commodity demand – particularly copper – is according to Brown, likely to need to rise for countries to both secure energy independence and to decarbonize the energy system. “The potential magnitude of this required public and private investment, in our view, puts a higher floor under commodity prices that may somewhat offset the traditional cyclical risks.”
In Brown’s view, global economic activity is decelerating, but not to the point of an outright contraction in demand that shifts commodity markets from deficits to surpluses on a sustained basis.
Importantly, China is unlike nearly all major regions in that activity is poised to improve, says Brown. “Beijing’s willingness to deliver measured but meaningful stimulus is not in question. Better public health outcomes will allow for evidence of this support to appear in the data. China is the dominant driver of demand for many commodities, so this positive inflection may meaningfully offset the slowing in developedmarket demand growth.”
Outside of China, the policy outlook is mixed at present, finds Brown. “On the one hand central banks have signaled or embarked upon aggressive rate hiking campaigns to cool activity and inflation. But on the other hand, fiscal authorities are largely opting for subsidies that allow for energy demand to be sustained, rather than energy-conservation measures.”
It still makes sense to be overweight commodities and associated equities despite the widespread concern over the growth outlook, concludes Brown. “Sentiment has shifted much more than the underlying fundamentals, with a mass exodus of investors from commodity-linked exchange-traded funds over the past month (Exhibit 5). Additionally, these assets are useful from a portfolio construction standpoint in hedging any additional geopolitically-induced negative supply shocks.”