Multi-Asset Solutions Monthly Strategy Report
Global markets and multi-asset portfolios
Exhibit 1: MAS asset class views from March strategy summit
Commodities in focus
An important element of the current macro environment is the rise in commodity prices. Outside of precious metals, each of the major commodity subclasses has performed well this year, with livestock, energy, agriculture and industrial metals all outperforming MSCI ACWI. But is this the start of something bigger for commodities, and how do higher prices impact inflation, policy, and other asset classes?
Commodities: Recovery play or start of a “super-cycle”?
Investors are trying to disentangle cyclical and structural dynamics within commodity markets. As a rule, commodities respond to supply and demand dynamics in the near-to-intermediate term, rather than pricing in conditions further in the future. For most commodities, fundamentals look supportive. In oil markets, both the West Texas Intermediate and Brent curves have recovered to pre-COVID-19 levels of backwardation (when current prices are higher than where futures are trading), while disruptions to oil pipeline infrastructure in the U.S. have supported gasoline prices. In metals markets, iron ore has broken through $200/mt to reach all-time highs, driven by persistently strong Chinese steel production (although steel mills may be front-loading production ahead of potential activity curtailment). Copper prices hit $10,000/mt, with inventories low and end-use demand for consumer goods booming. Agricultural and livestock markets have also been strong, with a drought in Brazil curbing corn supply and restaurant re-openings supporting pork demand.
While it is possible that a confluence of positive factors has left commodities running a little hot, some investors have suggested that the recent rally marks the start of a “super-cycle” (broadly defined as a sustained period of rising commodity prices, such as that following China’s emergence as the dominant commodity buyer). The supposed drivers of today’s super-cycle are twofold: demand driven by green fiscal spending, and crimped supply. The demand argument suggests that fiscal spending to meet climate goals will be commodity-intensive. This is really a copper-centric story, as copper is needed to support wind, solar, electric vehicle, and battery infrastructure. The supply argument suggests that commodity producers, including energy producers, are not ready to meet demand growth, even as the global economy becomes less carbon-intensive.
The biggest test for the super-cycle theory will come in some quarters’ time, as the policy response to the pandemic wanes. Chinese demand still accounts for a good portion of overall demand for many commodities, and a majority for some, including copper (60%). Hence, any moderation in commodity demand in China, even as green investment remains steady in places like Europe, will be key to watch. For now, macroeconomic conditions do paint a positive picture for commodity prices: global growth looks likely to remain above trend for some time, the Federal Reserve (the Fed) looks committed to easy policy, and the U.S. dollar appears to be in the middle of a medium-term downtrend.
Developed and emerging market inflation, and policy
Among commodities with rising prices, oil is leaving by far the largest footprint on inflation data. The energy component of the U.S. consumer price index, for example, jumped 25% year-on-year (y/y) in April, with gasoline alone up nearly 50%. In most economies, the year-on-year peak in energy prices should occur by May, with a fairly rapid retreat thereafter. Other commodities will likely have a limited influence on consumer prices, as they represent a modest share of input costs for the vast majority of goods and services. In the U.S., for example, broad commodity prices, with a one-year lag, do display a modestly positive correlation with core inflation, but with a tiny pass-through coefficient. We expect near-term inflation developments to depend much more on reopening and supply-chain dynamics than on commodity prices, with wage and productivity trends decisive in the longer run.
Developed market (DM) central banks will very likely look through commodity-related swings in headline inflation, as they have done for the past few decades. While not all central banks have formally changed their reaction-function framework as the Fed has done, DM monetary policymakers in general are hoping to push up inflation expectations somewhat and to generate higher inflation than was experienced in the last cycle; they see hot-running economies as a means to these ends. They will judge their success only over time, and we do not expect any major DM central bank to raise policy interest rates before 2022, with the Fed likely to move in 2023. As Chair Powell mentioned at a recent press conference, the Fed is keenly aware of the high inflation that characterized the 1960s and 1970s and will act to prevent a repeat of that experience. But policymakers will take large and sustained rises in medium-term inflation expectations or signs of generalized and lasting rises in the services price level—not a few months of high-side headline inflation readings—as warning signs.
Higher inflationary pressure from rising commodity prices will likely be more of a concern for emerging markets (EM) central banks. Given the amount of spare capacity in most EM economies outside of Asia, we are not seeing broad-based inflationary risks in EM. However, a combination of higher commodity prices and the year-ago base effect could push headline inflation in EM sharply higher in the coming months. In fact, both average EM headline and core CPI inflation have picked up since the start of the year.
Even though the jump in headline inflation could be temporary as the base effect eases later this year, it could force central banks with challenged inflation targeting credibility to tighten earlier than previously expected. Indeed, we have already seen rate hikes in Russia and Brazil as headline inflation breached the upper bound of official inflation targets.
Meanwhile, we do not expect monetary tightening in North Asia in response to higher commodity prices. China’s PPI inflation has risen notably in the past few months amid strong industrial activities and higher raw materials prices, but CPI inflation remained subdued at 0.9% y/y in April and is expected to remain below the People’s Bank of China’s (PBoC’s) ceiling of 3% this year. In our view, the rapid PPI reflection is unlikely to lead to a policy rate hike in China given limited spillover from upstream producer prices to consumer prices historically. More importantly, Chinese policymakers may see the recent rise in commodity prices as driven more by external factors, including global demand recovery fueled by policy stimulus and supply side constraints, which cannot be directly mitigated by domestic policy tightening. In Korea and Taiwan, we also expect the central bank to look through the temporary rise in headline inflation given subdued underlying inflationary pressures.
Commodity-exposed stocks have benefited from higher prices
In general, the importance of commodity sectors to equity markets has been on a downtrend. Ten years ago, the materials and energy sectors accounted for around 20% of MSCI AC World Equity market capitalization vs. 9% today. As a result, even as commodity stocks have shot higher over the past three months, moves in the larger sectors of the market, such as consumer and technology, have been more important to index performance.
That said, there are regions where commodity-exposed stocks are better represented than in the global index. In the UK, multi-national commodity producers account for over 30% of the FTSE 100. The Canadian stock market has a 25% weighting toward commodity sectors. In Australia, the major iron ore producers account for 22% of the index. These markets’ earnings streams are directly supported by higher commodity prices, and, all else equal, these stocks should perform strongly as prices rise. Among these sectors, energy stocks stand out as offering the greatest opportunity: UK listed energy stocks remain 32% below levels seen in February 2020, before the onset of COVID-19, and have trailed the recovery in longer-dated oil contracts (Exhibit 2).
Energy stocks are trading significantly below levels seen before the COVID-19 pandemic, and their relative performance is yet to catch up with strength in oil prices.
Exhibit 2: Twelve-Month forward Brent Oil and UK Energy's relative performance
Commodity prices may be impacting equity markets in other ways as well. Higher commodity prices may be leading to higher input costs—a negative drag on margins. There is some evidence of this effect in PPI data, and the recent earnings season was littered with company commentary on this topic. However, for most companies, any rise in input prices is likely to be swamped by stronger revenues, leaving us optimistic on the outlook for margin expansion. To the extent that higher commodity prices are moving bond yields, the trend may also be raising the cost of capital, contributing to the re-rating seen in some of the more expensive parts of the stock market.
Asset allocation implications
The positive outlook for commodities is contributing to positioning in our multi-asset portfolios, most notably via our exposure to the UK equity market, which has been trading with a value bias, and our moderate underweights to duration. With energy markets accounting for 44% of the default volume in U.S. high yield markets in 2020, higher oil prices are a fundamental support to our credit positions, though we would note that spreads are already tight.
More generally, our portfolios continue to reflect a pro-risk view. With the U.S. economy reopening and vaccine rollouts accelerating across key regions, we are confident in expecting strong global growth. This month, our quantitative signals increased their preference for stocks over bonds, and though the market appears concerned about inflation near-term, our positive view anchors on a supportive policy position and the growth environment. Within our equity exposure, we prefer value to growth, and cyclicals to defensives, and within bond markets we prefer Italian and Japanese bonds over UK and Canadian bonds.