Commodities have no friends at the moment.
From energy to softs to base and precious metals, prices have been hammered almost unilaterally across the board, weighed down by a combination of a strengthening US dollar, increased supply, tepid demand and, as a consequence, mounting disinflationary pressures.
The paragraph below, from Macquarie Bank’s commodity analyst team, is reflective of the broader investor mood when it comes to commodity markets – they hate them.
The world simply hates commodities at the moment. Prices keep on falling, producers are in a battle for survival and, more worryingly, demand isn’t reacting that positively as of yet. They are providing a catalyst for currency volatility, causing headaches for many emerging market governments and leading to wider concerns around systemic financial risk. This is particularly true as deflationary pressure intensifies which in turn drives business caution and amplifies the fundamental problems pervading commodity markets. We remain in the wrong type of global economy for commodity prices to perform well.
According to Macquarie, there is only one thing that can break the current cycle of ever-lower commodity prices.
Unfortunately for those hoping that 2016 will herald a year of accelerating global growth, they believe supply, not demand, holds the key for a move higher in prices.
According to the bank, the crude oil market, in the midst of a severe supply glut at present, holds the key to not only stabilising prices for the energy sector, but the broader commodity complex as a whole.
In recent times oil has been leading everything lower. Moreover, the lagged deflationary pressure will push industry cost structures (and pain points) for other commodities even lower. However, we expect global crude oil markets to return to seasonally normal supply-demand balances by 3Q16, while 2017 will be the first year in five that results in an annualised inventory draw. We expect the resulting oil price recovery will at least go some way to breaking or even reversing the current global deflationary downcycle.
Macquarie suggest that the slumping crude oil price has kept more marginal producers of other commodities in production, lowering their running costs and, as a consequence, keeping markets awash with supply that would normally be displaced in the past.
However, given their expectation that the crude market will return to normal supply-demand by the September quarter this year, this will help to support crude prices, placing additional cost pressure on marginal commodity producers.
This chart from Macquarie shows where major commodity markets currently sit in the price cycle, in the bank’s opinion. Essentially, those commodities moving towards the green areas are those likely to see price gains, while those in red will likely see further price declines.
Based on this assessment, the bank has compiled a list of commodities that they expect will outperform over the next two years, along with those likely to benefit from short-term seasonality factors along with those to avoid.
They suggest that oil, US natural gas, zinc, palladium, silver and cobalt are all likely to outperform over the next two years.
In terms of defensives, they prefer gold and uranium while for short-term investors – and perhaps the brave – they like iron ore, nickel and alumina – the first on an expected seasonal uplift in demand from China with the latter two on potential supply cuts.
As for those to avoid, Macquarie suggests that potash, thermal coal, aluminum, steel and nitrogen are likely to remain under continued price pressure for the foreseeable future.
“We are still at the point where things need to get worse before they get better, in order to ensure the necessary supply response. Indeed, the combination of continued macroeconomic headwinds and weak fundamentals mean the near term risk remains skewed to the downside in most cases,” suggest Macquarie
“Assuming some degree of macroeconomic stability into H2 (potentially a big if), and the potential for a nascent emerging market recovery, we believe oil will be one of the first to benefit.”