Commodities have been the most challenged asset class this year by far. Equity performance is now modestly negative, at least in the United States, while bond markets have once again managed to defy expectations and eke out a slight gain. But the entire commodity complex has suffered, with the most severe losses in cyclical commodities, such as oil and industrial metals.
Commodities have been hurt by several, interrelated trends. Demand has suffered as global growth has slowed, particularly from commodity-intensive emerging markets. Slower growth has also been associated with a severe drop in inflation expectations, which, since commodities are viewed as a hedge against inflation, has led to a collapse in investor demand. Instead, investor focus has shifted away from concerns over excessive quantitative easing and toward the possibility of another recession. In addition, commodities have struggled under the weight of a stronger dollar.
The supply side of the equation has also been challenging, particularly for energy. A greater than 50% reduction in the U.S. rig count has done little to slow the increase in U.S. domestic oil production. As shale producers improve efficiency, production has risen. Today, the United States produces roughly 700,000 barrels per day (bpd) more than a year ago. At the same time, following the tentative nuclear accord with Iran, many Gulf states are ramping up their own production in what appears to be a somewhat desperate effort to maintain market share.
So what is the outlook for commodities? Given the outlook for global growth we are not expecting an imminent or strong rebound in prices, although lower prices nevertheless are having an impact on demand. Oil should level off around current levels, but it is hard to imagine a strong rebound in the absence of a sharp reduction in non-U.S. production.
What does it mean for investors? All of this leaves the commodity producers as a more interesting opportunity than the physical commodities. For investors with a longer-term view, say three to five years, some bargains are beginning to emerge. However, even here investors need to exercise selectivity. To be sure, most commodity-related sectors are cheap, but in many instances the plunge in valuations merely tracks the drop in earnings and profitability. Where we do see some relative value is in U.S. drillers, U.S. refiners and metals and mining firms.