Outlook for commodities positive, despite near-term squalls

Key points

• Historically, commodities have been particularly helpful in hedging a portfolio against inflation and geopolitical risk, two factors seen in spades of late
• However, after an initial surge in commodity prices following the Russian invasion of Ukraine, prices have plunged 24% since June 2022 – with energy prices hit the most
• Volatility has been high for commodity prices in the last 12 months and will probably remain so until more certainty emerges on the outlook for global growth and inflation. That said, there have been bright spots – industrial metals have gained on the reopening of China’s economy
• The longer-term picture for commodities seems encouraging, and adding commodity exposure can also help diversify a portfolio of stocks and bonds

Broad-based commodity prices have plunged by 24% since their peak on 9 June 2022, as fears of a recession and potential demand destruction gained traction.  

Based on the S&P GSCI Commodity price index, the decline was mainly driven by energy (-33%), industrial metals (-9%) and agriculture (-16%), while precious metals added 6% over the period (see chart).

Hedge against inflation and geopolitical risk  

On a 12-month view, commodities can be particularly helpful in hedging a portfolio against inflation and geopolitical risk. 

Commodities have historically been one of the best hedges against inflation. 

• Typically, industrial metals have been the best performing commodity in periods of high inflation, between 3% and 5%.  
• Precious metals (and gold in particular) have been the best performer in periods of very high inflation (above 5%). 

For more details on the sensitivity of commodities and other asset classes to inflation surprises, and to the inflation factor more generally (combining inflation surprises and inflation prints), see How to diversify portfolios and hedge inflation risk: from commodities to bitcoin (November 2021)¹ and How to diversify investments whatever the macro weather (October 2021)²

Volatility is likely to persist in the near term   

However, in the near term, commodity prices are likely to remain very volatile, as the growth and inflation outlook remains highly uncertain.  

Price action is likely to be driven by the news flow around the geopolitical situation and energy supply levels in Europe, as we as the reopening of the Chinese economy, after the government suddenly lifted its zero-COVID policy in December, Beijing’s policy support, and the state of global supply chains. 

Short-term risks versus longer-term opportunities  

The following section looks at the short-term risks and longer-term opportunities for energy, industrial metals, and precious metals in more detail.

Energy: short-term volatility but tight supply should support long-term prices

Energy prices soared between January to mid-June last year, following the EU’s embargo on Russian oil supplies and the Organization of the Petroleum Exporting Countries’ (Opec) reluctance and inability to increase output. 

However, prices have since rolled over as the risk of a recession increased, along with potential demand destruction. The price of Brent declined from a peak of $128 a barrel in March 2022, to $78 a barrel in March 2023.

While global demand for oil and gas is at risk from an economic slowdown, energy prices should be supported by tight supplies, geopolitical tensions and rising Chinese demand. The country’s domestic and international travel has already rebounded strongly, and is starting to feed through to more demand for oil. Increased restrictions on Russian oil will probably also support the price.

However, in the near term, energy markets are likely to remain highly volatile. Any setback in China’s recovery or disappointment in global economic activity would adversely hit energy prices.

There is much uncertainty in the market at present, with futures markets predicting a decline in the price of Brent crude oil, from $78 a barrel in March to $76 a barrel by year-end and $73 a barrel by December 2024. Analysts are more optimistic and anticipate that the price will jump to $90 a barrel by year-end (according to Bloomberg’s median forecast on 28 March) with forecasts ranging between $69 and $110 a barrel.

Industrial metals: short-term volatility but, supported by structural trends over the long term 

So far, the market has played the China reopening story primarily through industrial metals. They have gained 16% from their September low (on the 28th of the month), with copper and iron ore up as much as 21% and 24%, respectively. There has been little sign of an increase in industrial metal demand yet, but manufacturing activity is expected to pick up through the year. 

China represents about 50% of the global demand for metals (and as much as 65% of seaborne iron ore demand), so it is not a surprise to see prices rebound strongly. But it also means that metal prices are very sensitive to Chinese growth (see chart), and they would be vulnerable to any disappointment in the recovery process.  

The long-term outlook for industrial metal prices remains underpinned by favourable long-term supply and demand dynamics. Supply is tight, following under-investment from mining companies over many years. Meanwhile, demand should be supported by the energy transition, especially towards renewable sources.

Precious metals: attractive diversifier while inflation and geopolitical risks remain, but fundamentally expensive  

In the current environment, gold should continue to play its role as an attractive portfolio diversifier. The appeal of the yellow metal generally endures as long as inflation, recession and geopolitical risks hang over markets. 

However, based on its relationship with real yields, gold appears fundamentally expensive and seems to offer limited upside potential from current levels.  

Historically, gold has been negatively correlated with real yields (see chart). This relationship broke down in February 2022, after Russia invaded Ukraine, with gold prices remaining resilient in the face of rising real yields. However, prices would be at risk if geopolitical tensions receded and real yields remained elevated.  

Long-term commodities story remains intact      

Summing up, commodities appear to be an attractive hedge against inflation and geopolitical risk over the next 12 months. While industrial metal prices have already benefited from the boost to sentiment seen this year around the re-opening of the Chinese economy, energy prices have seen little benefit yet.  

With travel being one of the main beneficiaries of the country’s re-opening so far, the resulting increase in the demand for oil should act as a tailwind for the oil price.