Advisers looking for value in the commodities sector may wish to consider exposure to industrial metals within clients’ portfolios argues ETF Securities
Commodities have enjoyed a great start to 2018, from the low point mid-December they have rallied 6.5%[1], the performance has been broad-based too, driven not only by the Iran issues inflating the oil price but a rally in industrial/precious metals and agriculture.
We are wary of some who are interpreting this as being a positive sign for broad commodities this year. Commodities as an asset class are a very heterogeneous group and we expect varied performance from each.
Gold
Although we expect the Fed to continue to tighten policy, we think the downside risks to gold prices are limited because real interest rates are likely to remain depressed as inflation gains pace in the US. However, a shock event, such as an equity market correction, could force gold prices higher. On balance we see little change in gold prices in the coming year. Investors appear to be optimistic about gold despite the rising interest rate environment, we believe this is due to investors now seeing gold as an insurance policy from geopolitical concerns rather than investment.
Figure 1
Industrial Metals
We expect the most interesting commodity in 2018 to be industrial metals. They are likely to benefit the most from improving emerging market (EM) growth, at the same time we expect supply to remain in deficit in 2018 as the lack of investment in mining infrastructure continues to bite.
Emerging market demand is crucial for commodity markets as they represent 70% of industrial metals demand. In this respect, we expect any weakness in commodity prices to be largely offset by solid demand growth, again led by China. Although concerns remain over the build-up of debt, Chinese policymakers have continued to show a willingness to support the financial system with stimulus to ease financial conditions.
Since industrial metal prices began to fall in 2011, capital expenditure by miners collapsed. In mid-2017 capital expenditure by the largest 100 mines was 60% lower than in mid-2013[2]. Given the long lag times behind investment and completion of mines, we don’t expect the tightness of mine supply to reverse any time soon.
Miners seem to have been cautious to increase spending as they wait for the price recovery to prove sustainable. Historically we have seen about a year-long lag between a recovery in price and a recovery in capital spending. It is likely in 2018, as commodity prices continue to rise, that we see capital expenditure growth turn positive, although the damage of 4 years of lack of investment in to mining infrastructure has already occurred and is why industrial metals remain in a supply deficit.
Figure 2
Historically we have found that metal markets begin to move towards a balance two years after miner profit margins hit rock-bottom. Miner margins fell to a low of 2%[3] at the beginning of 2016 and since have recovered to just over 7%[4]. So if we see a repeat of historical patterns, we should see supply begin to improve in late 2018, but it could take years to move back into balance.
[1] Source: Bloomberg as of close 5th Jan 2018
[2] Source: Bloomberg, WBMS, ETF Securities as of close 13 November 2017
[3] Source: Bloomberg as of close 22 November 2017
[4] Source: Bloomberg as of close 22 November 2017
