By Jade Fu, Investment Manager at Heartwood Investment Management
- We retain a cautious outlook on the commodities sector as oversupply is expected to persist.
- Excess oil inventories, however, should begin to decrease over the course of 2016, leading to a more balanced scenario towards 2017, and demand is expected to improve gradually.
- China’s structural slowdown and expected consumption will be crucial for the industrial metals sector, where the fundamentals remain mixed.
- The Federal Reserve tightening cycle is likely to be very gradual and should not have a detrimental impact on commodity prices.
We have held a long-standing underweight position in the commodities sector and our cautious view is expected to remain in place in 2016. Despite bouncing back mid-year, the commodities market has fallen by more than 20% in the year-to-date, as measured by the S&P GSCI. The renewed slide in the oil price on global growth concerns and rising US oil inventories has contributed to market weakness, as energy remains the dominant driver of the commodities sector’s performance.
Looking ahead to 2016, we expect oversupply to be a persistent theme. More recently, financial markets have been particularly frustrated by indicators showing that US stockpiles remain elevated. Market consensus forecasts, however, suggest that while the supply surplus is expected to continue until at least the latter part of next year, excess oil inventories should begin to decrease over the course of the year. And this eventually should lead to a more balanced scenario towards 2017. Indeed, many observers are anticipating that oil will be in deficit from early- to mid-2017. With that said, US oil production can adjust quickly so any significant move higher in the oil price is likely to be contained. Barring an exogenous event, such as geopolitical risk, the oil price may bounce around, but we are not expecting any meaningful and sustained move in either direction, at least in the first half of 2016.
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Demand for oil, meanwhile, is expected to grow gradually, driven by Asia and the US. Global growth concerns have centred on China’s slowdown, which has exerted downward pressure on commodity prices more generally. Recently, though, investor sentiment appears to be less bearish on China, despite continuing data disappointments. In our view, the Chinese authorities continue to have the tools available to achieve a managed slowdown as the economy structurally adjusts. Moreover, we are expecting to see a stabilisation in growth in the coming months.
China’s structural slowdown and expected consumption will be crucial for the outlook across other areas of commodities, including industrial metals. Here, the fundamentals remain mixed. The Chinese property sector is an important bellwether of demand for copper and steel. Recent data point to signs of a property recovery, but market forecasts suggest that copper will remain in excess supply globally next year and in 2017. Longer-term, however, the supply-demand picture for copper looks more supportive. Other metals- zinc, nickel and lead – have a better fundamental outlook as the supply/demand outlook appears supportive in the near term, although higher Chinese inventory levels for those metals remain above their long-term average. Strong Chinese production has also driven the global surplus of aluminium, which is likely to weigh on performance, while there are questions about the longer term demand for platinum and palladium.
In agriculture, oversupply remains an issue for corn, soybeans and wheat, although the sector is counter-cyclical and less dependent on global growth. Weather, of course, is a dominant factor too.
What about the impact of Federal Reserve policy? Higher US rates and a strong US dollar are always risks for commodity prices more generally, but the anticipated Federal Reserve interest rate tightening cycle has been well telegraphed and the pace of hikes is expected to be slow and gradual. In this environment, we are not expecting that Fed rate hikes will have a detrimental impact on commodity prices.
Overall, therefore, we expect to see this year’s story of oversupply persisting. From an asset class perspective, we continue to believe that equities offer more attractive risk-adjusted returns versus commodities.