The asset class has risen 35% in euro terms over the past 12 months, and the rally looks far from over, due a combination of tailwinds as the world recovers from Covid-19, says Van der Welle, strategist with the Robeco Global Macro team.
“Deploying our asset allocation framework factors of macroeconomic developments, momentum, valuation and sentiment, we conclude that commodities in general – and metals in particular – have become anything but rusty,” he says. “Instead, commodities still shine.”
“Commodity markets are clearly enjoying strong and positive momentum at this juncture, seeing the strongest price gains on short one-month momentum across the multi-asset universe.”
“Strong short-term momentum gains such as those observed in metals such as copper and aluminum likely signal further price gains in the near future.”
The valuation of commodities has become more favorable, as can be seen in a metric commonly used to value them – the roll yield. This is one of the three components of commodity returns, next to spot price movements and the cost of carry. Technically, the roll return is defined as the change in the futures price minus the change in the spot price.
Roll yields stem from the shape of the commodity futures curve. They are positive if the futures curve of a commodity is in backwardation, meaning that a longer-dated futures contract converges to the higher spot price upon expiry. For a buy-and-hold investor who keeps rolling over their commodity futures exposure, this simply boils down to buying low and selling high.
The reverse scenario occurs when the futures curve is in contango, which means a longer-dated futures price converges to a lower spot price upon expiry. This has often been a drag on total commodity returns in the past decade as well as on those of some commodities last year.
“Looking at the current commodities futures curves, backwardation is the name of the game, implying positive roll returns so long as the shape of the curve remains the same,” says Van der Welle. “This especially holds for metals such as copper.”
“The current backwardation of around half of the commodity futures curves reflects supply-side pressures in a global economy that is facing higher commodity demand in the post-pandemic expansion phase. Backwardation implies higher spot commodity prices are needed to incentivize more capex and bring new supply forward.”
“It is not only the typical cyclical forces that one should expect in a early expansion phase of the business cycle that are at play here, such as increased mobility, pent-up travel demand and elevated goods consumption. The USD 2.25 trillion American Jobs Plan, for example, will give a more structural impetus to commodity-intensive investments in roads, bridges and railways in the coming years.”
The Paris Agreement goal of achieving net zero emissions by 2050 also bodes well for demand for the commodities used in building green infrastructure, particularly copper, aluminum and lithium, Van der Welle says. Lithium is the key component in electic car batteries.
“The knife of decarbonization cuts both ways here, as the supply side is also affected by the Paris 2050 climate ambition,” he says. “Given the high energy intensity of aluminum production and China’s desire for emissions to peak before 2030, production levels could fall globally precisely at a time when higher levels are needed.”
“Another macroeconomic element that keeps us bullish on commodities is our moderately bearish view on the US dollar. Commodities are largely priced in dollars, so a weaker dollar typically leads to higher commodity prices. Also, the reopening of the European economy, which is a net energy importer, supports commodity demand.”
Turning to sentiment, the rising inflation expected as the global economy expands again could be another tailwind, Van der Welle says. “Inflation risk ranks highest on the worry list for fund managers,” he says. “With the search for inflation hedges top of mind, commodities have seen inflows, as they are generally fairly accurate inflation hedges.”
However, China could prove to be a headwind. “Although we see the risks for the asset class as skewed to the upside, there are downside risks,” Van der Welle says. “The most prevalent is that the monetary policy tightening stance in China to force deleveraging in certain overheating sectors could inhibit commodity demand.”
“While the marginal demand may very well not be coming from China in the second half of this year given the huge policy stimulus elsewhere, China still matters for commodities. A deceleration in Chinese money supply growth has typically been followed by slower commodity price appreciation a few quarters later.”
“In all, while equity prices run a larger risk of exhaustion in the second leg of the reflation trade, as much of future earnings upside has been discounted, commodity prices must continually balance today’s supply and demand. This makes them perhaps even better suited as a risk-on proxy for the second half of 2021, given continuing tightness in physical markets as the economic reopening progresses.”