Can the commodities sector overcome recession fears?

THE commodities sector has rallied this year, outperforming other sectors of the market. In terms of sectors within the S&P 500, energy delivered the highest positive returns year to date. But despite being a big winner so far in 2022, fears of a global recession have raised caution over the commodities sector.

In view of the current high inflationary environment, central banks around the world have embarked on an aggressive rate hike cycle. The US Federal Reserve, for instance, hiked interest rates by 75 basis points for the second straight month in July in an effort to bring rampant inflation under control. More recently, Fed Chair Jerome Powell reiterated the overarching aim of bringing inflation back down to the 2 per cent goal in his annual address at the Jackson Hole Economic Symposium.

But with aggressive rate hikes underway, the economy is increasingly at risk of a recession. Beyond this, weak economic data coming out of China has also contributed to global recession fears, as China’s factory activity extended declines in August due to new Covid infections. Recession expectations have in turn dampened the near-term outlook for commodities.

Case for commodities

While we witness some demand concerns, we still cannot ignore the persistence of tight supply in the major commodities - energy, metals and agriculture - due to the following factors:

• Structural underinvestment in oil and gas

Unlike the 1970s and 2000s when capital expenditure grew alongside rising oil and gas prices, we are currently experiencing a contraction in capex even as prices rise.

Structurally, underinvestment has characterised the oil and gas sector, a persistent problem that is difficult to change. Based on International Energy Agency data, annual investment in upstream oil and gas peaked at around US$780 billion in 2014, and has been on a downward trend since.

ESG (environmental, social and governance) has also become an increasingly important for the oil and gas industry, due to producers’ internal climate policies and external pressure. Hence upstream spending is falling.

Oil majors (Chevron, ExxonMobil, Shell, BP) broke profit records in their latest earnings reports. But they remain focused on returning cash to shareholders and conducting share buybacks, rather than ramping up capital expenditures.

• Low inventories of metals

The metals markets continue to face some of the tightest supply conditions ever, with inventories dwindling globally and little sign of significant new supply. For instance, aluminium and nickel stocks have fallen the most this year, as they are among the most exposed to disruptions in Russian supply.

Beyond this, longer-term structural trends provide the segment with multiple tailwinds. Renewable energy technologies rely heavily on key metals and minerals, including copper, aluminium, zinc, cobalt, nickel and lithium. In the longer term, the energy transition will spur a strong demand for such metals.

• Food security concerns

Extreme weather conditions are becoming more commonplace due to the effects of climate change. Agricultural supply is highly weather dependent and therefore especially vulnerable.

The recent heat waves in Europe, where temperatures soared above 40 deg C in France, Greece, Spain and Portugal, have threatened the seasonal harvest. India, which accounts for 40 per cent of global rice exports, faces a lack of rainfall in West Bengal and Uttar Pradesh. This has caused India’s total rice planted area to shrink by 13 per cent, taking a toll on the global agricultural supply.

China is also now experiencing persistent heatwaves, with the hottest conditions since 1961. The sweltering conditions are causing its waterways to evaporate, such as the Yangtze River basin, which stretches from coastal Shanghai to Sichuan province in China’s southwest.

In addition, food protectionism is on the rise as governments try to safeguard local supplies. Around 30 countries have taken steps to restrict food exports since the start of the war in Ukraine; agricultural protectionism is at the highest level since the food-price crisis in 2007 and 2008.

The big picture

We are in unprecedented times with respect to the commodities sector. The convergence of multiple factors, including war, underinvestment in supply, record inflation, and the energy transition, has created many opportunities in this space.

The commodities sector historically shows a positive correlation with inflation. For instance, the S&P Global Natural Resources Index has a 10-year correlation of 0.6 with the US Consumer Price Index.

More importantly, beyond the immediate ebb and flow of commodity prices, enduring trends underpin this particular asset class. As such, investors may consider the Blackrock Natural Resources Growth & Income Fund. It is representative of the commodities sector, with an allocation to the energy, mining and agriculture sectors.

Alternatively, they may consider the JPMorgan Global Natural Resources Fund, which invests in natural resource companies, such as those in oil and gas exploration and production, and in metals and mining.

Lastly, agricultural commodities are also set to benefit. For exposure to the agribusiness sector, there is the VanEck Agribusiness exchange-traded fund (ETF). This is a pure equity ETF, comprising companies involved in farm equipment, seed and fertiliser, animal health, food transport and processing industries.

The writer is a research analyst of the research and portfolio management team at FSMOne.com. FSMOne.com is the business-to-consumer (B2C) division of iFAST Financial Pte Ltd, the Singapore subsidiary of SGX Mainboard-listed iFAST Corporation Ltd.