Turning to commodity markets for direction

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below. 

All data referenced in this article is sourced from LSEG Datastream unless otherwise stated, and is accurate at the time of publishing.

Key points

• Equity markets have remained incredibly resilient this year, in spite of rising bond yields, heightened geopolitical tensions and higher oil prices
• With rates likely to stay higher for longer, the ‘Goldilocks’ narrative that has propelled equity markets to recent highs looks challenged. This means that in the absence of a significant improvement in corporate earnings, markets appear vulnerable to downside risk in the near term
• But while the upside potential looks limited at the index level in the near term, investment opportunities remain under the surface. The recent pro-cyclical sector rotation in equities has been inconsistent with the risk-off moves observed within other asset classes. Those disconnects are unlikely to persist, signalling relative value opportunities
• This article turns to commodity markets as a guide of what the future may hold for equities and how to position at the sector level, if the ‘no-landing’ scenario does not materialise. We highlight a couple of defensive sectors which appear dislocated based on their historical relationship with commodities, and which look cheap relative to history

Equity markets have remained buoyant this year despite a slew of headwinds, from rising bond yields, to heightened geopolitical tensions and higher oil prices. Following a 3% pullback in April, global equities are 20% above their October lows. 

However, internal dynamics within other asset classes paint a more cautious picture. This article turns to commodity markets as a guide of what the future may hold for equities, and what this could mean for positioning at the sector level.

Equity markets have been resilient in the face of uncertainty

The resilience of the equity market has been remarkable considering the sharp repricing in rate expectations in the past four months, following hotter-than-expected US inflation prints and more hawkish communication by the US Federal Reserve (Fed). 

Market participants have recalibrated their expectations and now anticipate approximately 40 basis points of rate cuts by the Fed by January 2025, down from over 180 basis points at the start of the year. Rates are expected to be higher for longer, with the first cut unlikely before September, and with some even expecting no cut in 2024. As a result, US 10-year yields have surged from 3.8% in December, to 4.7% in April.

This obviously challenges the ‘Goldilocks’ narrative that has propelled equity markets to recent highs, predicated on economic growth remaining resilient and rates coming down.

This strength is at odds with the ‘risk-off’ moves seen in other asset classes

The equity market strength and internal dynamics have been inconsistent with the risk-off moves observed within currency and commodity markets in recent months.

The US dollar (USD) is up 5% year-to-date against the currencies of its major trading partners, and up to 9% against commodity and cyclical currencies, such as the Norwegian krone and the Swedish krona. Similarly, precious metals have outperformed industrial metals by 13% since October. 

Historically, such moves have tended to be associated with periods of increased risk aversion across and within asset classes, with global equities typically lagging bond returns and cyclical sectors underperforming the more defensive ones (see chart). Instead, over those periods, global equities have outperformed bond returns, while cyclical sectors have outperformed the more defensive ones.

The pro-cyclical sector rotation in equities has been inconsistent with the risk-off moves in commodity markets in the past few months

Relative six-month performance of global cyclical versus defensive sectors, compared with that for industrial metals versus precious metals

Much improvement in economic activity seems needed to sustain equity market moves

If history were to repeat itself, we would need to see a significant improvement in economic activity for those moves to be sustained (see chart). After 16 months in contraction territory, the US manufacturing cycle is showing tentative signs of stabilisation. The ISM Manufacturing Index rose just above the 50 mark in March, the limit between expansion and contraction in economic activity. However, above-trend economic growth would be required, in our view, only to justify current market levels. 

The recent outperformance of cyclical versus defensive equities assumes above-trend economic growth 

Relative 12-month performance of global cyclical versus defensive sectors, compared with the ISM Manufacturing Index

While the upside potential looks limited at the index level, investment opportunities remain under the surface

With rates likely to be higher for longer and geopolitical uncertainty lingering, equity valuations could be challenged in the coming months. This means that strong earnings delivery is required for equity indices to power ahead. 

Analysts currently expect corporate earnings to grow by 9% in 2024 and 13% in 2025 globally. This is above the long-term average of 8% over the past 50 years and could prove optimistic at this stage of the cycle. 

Encouragingly, the high-level of concentration, as well as extended sentiment and positioning in parts of the equity market open the door to some broadening in leadership. In other words, while the upside potential may be limited at the index level in the near term, investment opportunities remain under the surface. 

As mentioned previously, the recent outperformance of cyclicals versus defensives may be overdone, if the ‘no landing’ scenario does not materialise, and the global economy does not grow above trend in the next couple of years. This leaves upside potential for the more defensive parts of the market.

Consumer staples and utilities appear dislocated and cheap 

Some sectors have underperformed significantly in recent months and appear dislocated based on their historical relationship with commodity markets. More specifically, the underperformance of consumer staples and utility stocks globally over the past six months looks overdone given the outperformance of precious metals versus industrial metals. This is especially true against cyclical sectors such as industrials and financials.

Valuations also favour consumer staples and utilities globally, but even more so in Europe (see chart). European consumer staples are now trading at 15.8 times forward earnings, 16% or 2.4 standard deviations below their 10-year average, based on MSCI indices. Similarly, European utility stocks are currently trading at 11.9 times forward earnings globally, 17% or 2.0 standard deviations below their 10-year average. In contrast, global equities are trading at a 6% premium to their historical average.

European consumer staples and utility stocks look particularly cheap in a historical context

Forward 12-month price-to-earnings multiples of the MSCI Europe consumer staples and utilities sectors

In summary …

With rates likely to stay higher for longer, the ‘Goldilocks’ narrative that has powered markets in recent months looks challenged. The recent risk-off moves observed in currency and commodity markets are at odd with the equity market’s leadership, and if history is any guide, commodity markets suggest that defensive sectors offer better prospects in the short term.