Something strange started happening at the beginning of 2018. For the first time in a long time, investors started asking us what we thought about commodities.
For the past several years, any time we talked about commodities, it felt like we were banging our heads against a wall. Investors were disinterested, and who could blame them? The performance of the asset class was nothing short of awful. To quote my colleague Jeff Weniger, commodities became the star of his “stinker study” starting back in 2013—and then they somehow performed even worse from there.
That said, we now have a few reasons to finally be positive on the asset class. As Jeff mentioned, commodities are a prime candidate for mean reversion, given a decade of disappointing performance. Continued weakness in the dollar has provided a tailwind for prices. From a demand perspective, China’s Belt and Road initiative may act as a boon as the total expenditure of the project could reach as much as $8 trillion by some estimates. President Trump has continued to float an infrastructure bill to improve the country’s aging bridges, tunnels and roads, which would be a particularly welcome addition for those of us in the Northeast.
Structurally speaking, contango in the futures curve of many commodities led to severely negative roll yields for a few years, but that has recently improved for several contracts. Additionally, as the Federal Reserve (Fed) continues along its rate hike trajectory, the collateral returns of commodities futures contracts have ticked up as well.
Inflation: The Elephant in the Room
But when making the case for commodities, the biggest determining factor almost always comes back to inflation. It’s no coincidence that several years of commodity underperformance occurred at the same time when inflation remained stubbornly low in the U.S. With the potential for faster economic growth and with increased Treasury supply that could help moves rates higher, the possibility of inflation coming back has risen. In fact, the five-year breakeven rate, the market’s measure of expected inflation, in early March hit the highest level in five years.
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